A Fiscal Policy Rule for Oil Exporters

This article originally appeared in the UAE's National, under the title

The price of oil is tied to government budgets

The graph in the version below is better.

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My uncle, a noted macroeconomist, recently asked me if I could suggest a fiscal policy rule for oil exporters to help them planning government spending in the face of volatile oil prices.    

Of course I could.  Here it is.

Oil is the life-blood of the global economy, and therefore GDP and oil prices tend to be related.   Therefore, it seems appropriate to use a model is based on global spend on crude oil as a percent of world GDP.  If oil prices are too low, supply will falter, the global economy will sooner or later become starved of oil, and prices will rise.  On the other hand, if prices are too high, then the consumer economies will stagnate, new oil production will come on line, and oil prices will decline. 

Source: BP Statistical REview, IMF, Prienga estimates and forecasts

Source: BP Statistical REview, IMF, Prienga estimates and forecasts

On the high side, oil spend equaling 5% of GDP implies ‘stagflation’, ‘secular stagnation’ or outright recession in the advanced oil importing countries.  Oil prices are not sustainable at that level without ascribing to some variation of peak oil.  Today, 5% of GDP equals about $110 / barrel.   That’s a very high price historically, and not suitable for fiscal planning purposes given current realities.

On the other hand, oil spend is rarely less than 1.5% of global GDP, which would seem to constitute a planning floor.   This leaves us with a rather unwieldy range of 1.5-5.0% of GDP for fiscal planning purposes.

But we can narrow this range.  Importantly, oil spend rarely falls into the range of 2.5-4.0%.  Only three years in the last 35 saw oil prices in this range.  Why?  We would argue that oil is either supply-constrained or demand-constrained.  If it is supply-constrained, then oil will become a shortage commodity, as we saw from 1979 to 1986 and from 2004 to 2014, and spend will range 4-5% of global GDP.  On the other hand, if the oil supply can respond flexibly to demand, then oil prices will be demand-constrained, implying spend of 1.5-2.5% of GDP, with an average of about 2% of GDP.    There is no middle ground, historically.  Either oil is a shortage commodity, or it is not.

Thus, much depends on one’s view of the future oil supply.  If you believe that oil will remain plentiful, then fiscal policy should assume an oil price equal to 2.0% of global GDP in the long run, perhaps a bit higher in the medium term. 

I would add that our expectations depend heavily on the experience after 1986, when oil prices last collapsed in such great magnitude.    At the time, a period of extended low prices was readily foreseeable.  High oil prices had been maintained by progressive OPEC production cuts, which in turn created global spare capacity equaling 13 mbpd, or 25% of global consumption.   This enormous surplus required almost 20 years to clear—two decades known as The Great Moderation.  However, there is no such surplus today.  Indeed, surplus capacity is probably not more than 1-2% (1-2 mbpd) of oil consumption, a level which would ordinarily be considered critically low.

On the other hand, the world has roughly 300 million barrels of excess oil and product inventories.  Even if drawn at the pace of 1 mbpd, they would last almost a year.  Second, shale oil appears to be a scalable resource, which can be brought back on line quickly if necessary.  If this is true, then a buffer exists—by far not as great as in 1986—but one which might last anywhere from a year through the rest of the decade. 

If one allows the 1986 precedent, then fiscal policy should be set assuming oil prices will equate to 2.3% of GDP, as they did from 1986 to 1990.  In dollar terms, that would imply a spot Brent oil price of $50 / barrel today, rising to $60 / barrel in 2020.  As Brent currently hovers around $48 / barrel, the sustainable price would appear to be above the current price.

On the supply side, maintaining such low prices looks quite a challenge.  At current prices, many shale operators are facing bankruptcy, the oil majors are liquidating themselves, and OPEC governments are suffering for a lack of revenues.  The situation looks untenable for producers.

To maintain low prices, China would have to suffer a recession--GDP growth of 2% or less--thereby pushing its neighbors into outright recession.  The script would follow the Asian financial crisis of 1998.  At the time, oil spend fell to 1.1% of global GDP, equal to $25 / barrel into today’s terms.  Of course, assessing China’s outlook is a complicated matter.  For now, let it suffice to say that maintaining current oil prices depends intrinsically on weakness in China, not on the ability of oil producers to flood the market at $50 / barrel Brent.

Those oil exporters who believe that oil is not a shortage commodity should plan for sustainable prices over the next five years at 2.3% of GDP, approximately $50-60 / barrel on a Brent basis.  For those who believe that China still has a future, and that oil is still hard to find, well, your analysis will be more complicated.