High oil prices disastrous for developing countries

Oil prices have breached the psychological barrier of US$80 per barrel today, as a result of a report by the U.S. Energy Information Agency which showed that crude oil inventories have sharply declined. The rise comes despite OPEC's recent announcement that it agreed to raise output by 500,000 barrels per day.

Norway's energy minister Odd Roger Enoksen says these high prices are 'justified' and that 'global oil markets are balanced'. Present high oil prices are needed to develop new resources in harder-to-reach places and offset rising production costs: "(Production) costs have increased a lot in the last couple of years, and we need a high price to develop new resources". Peak oil analysts would say that this is a discourse typical of oil producing countries that have maxed out. And indeed, Norway's North Sea oil fields have already hit that infamous peak.

Enoksen says record oil prices have a limited effect on that abstract thing called the 'global economy', but he does admit, by way of detail, that:

Of course the less developed countries can suffer from high oil prices but so far we have not seen threatening signs (of an oil-induced slowdown in global growth).

We don't see this as a detail. In fact, high oil prices are outright disastrous for developing countries and are already hitting them. The 'global economy' is dominated by a handful of highly industrialised countries whose economies are robust and can cope easily with volatility in energy prices. But for oil importing developing countries, representing more than 2 billion people, the situation is entirely different. Their economies are energy intensive and each increase in oil prices affects all productive segments of society immediately. Abundant and cheap energy is key to development. Scarce and expensive energy is detrimental to progress. The correlation is one of the best established relationships in development economics. The generic 'human development index' strictly correlates with the 'energy development index' (earlier post).

For the wealthiest countries (non-oil producing OECD), oil imports make up less than 2% of GDP, whereas for African oil importing nations this was more than 10% of GDP in 2006 (more here *.doc). In poor oil importing countries, oil price rises of the current magnitude imply a significant reduction of economic growth rates, an erosion of trade balances and a hike in inflation rates.

If coupled with low foreign reserves some of the effects of current high oil prices are: decreased import capacity, lower consumption and investment, lower production and employment. And as always, the poor are hit hardest as they face lower employment prospects, higher inflation (fuel, transportation, basic goods), and cuts in government spending on social services (in a recent report, when oil stood at around US$ 60 per barrel, the UN found that some of the poorest countries are already forced to spend twice as much on imported oil as on such fundamental social services as health care and education (earlier post). According to an African Development Bank document on the effects of high oil prices on African societies:

Lower employment prospects and the higher inflation rate will lower the purchasing power of the poor who have fewer (if any) instruments to hedge against the oil price increase. The biggest impact will be through higher price of kerosene which is used for cooking and lighting. The poor will also be affected by higher transportation costs. Clearly, higher petroleum costs will increase commuting costs and, especially in the case of agricultural economies, the cost of getting the crops to the markets.

Of the 47 poorest countries, 38 are net importers of oil, and 25 are fully dependent on imports (more here):
energy :: sustainability :: biomass :: bioenergy :: biofuels :: oil :: petroleum :: benergy economics :: developing countries ::

Given the limited availability of foreign exchange, these poor oil-importing countries face a number of options. Consumers and firms could decide to reduce their oil consumption but since the demand for oil is highly inelastic in the short-term, they may be compelled to reduce their consumption of other imported goods. Doing so could undermine economic growth especially if capital goods imports are affected.

Alternatively, countries could try to access foreign currencies to fill the gap and finance the energy bill. However, obtaining funds from private markets, bilateral and multilateral sources must be consistent with medium-term sustainability and sound debt management. In highly indebted poor countries, the only solution to fill the financing gap, and not to weaken growth, is to obtain grants or highly concessional loans. More importantly, governments will have to consider sustainable financing plans as all evidence points to oil remaining at high prices.

High oil prices will also exert a heavy toll on the budget both on the revenue and expenditure sides. On the revenue side, the tax base will be eroded if the profitability of oil-consuming companies is adversely affected and if unemployment increases. Expenditure could increase wherever governments subsidize oil products, or programs, which make intensive use of petroleum products. In that regard, an important question is if there should be complete pass-through of the oil price increase.

Governments are under heavy pressure to intervene to cushion the effect of the oil price increase. If the price of oil is not mean-reverting, price controls will lead to ever increasing losses which will ultimately be borne by current or future tax payers.

Subsidies to public utilities can also worsen the consolidated government budget deficit. In many countries electricity is produced using oil and is sold by law below its cost of production. In this case, the government will have to bear the additional expenditure from a higher oil bill. If the government does not have the resources to do so (for instance, if foreign reserves are too low), it may have to resort to rolling blackouts which have very adverse effects. Moreover, governments will themselves face higher energy bills through their own activities and that of state-owned companies.

Central banks may be tempted to tighten their monetary policy in reaction to the increase in inflation. Previous oil price shocks have produced significant increases in real interest rates which undermined domestic investment, pushed countries deeper into recession and produced stagflation. Furthermore, a rising fiscal deficit, combined with increasing public expenditures due to petrol consumption by public entities, can prompt the authorities to use monetary creation to finance the additional expenditures. As the increase in the price of oil is akin to a supply shock, an accommodating monetary policy would contribute to inflation. Non-inflationary policies are needed to avoid hyperinflation and to maintain monetary credibility.

For all these major problems, alternative sources of energy may offer a way out provided they are produced locally and can compete with oil. Many developing countries have the natural resources and the agro-ecological conditions to produce such competitive biofuels. But this would require significant investments in these countries, known for their difficult investment climates.

In any case, it is high time for the energy and development think tanks of this world to start working on a study showing the social and economic effects of high oil prices on the economies of the poorest countries and the potential for biofuels to mitigate these effects. Such an exercise could demonstrate the fact that biofuels have an important role to play not just in mitigating climate change, but in shielding the poorest countries from the catastrophic effects of high oil prices. Biofuels are not merely 'green', they are 'red' and 'blue' too - they can bring social justice and security.

References:
Reuters: Norway says high oil prices justified - September 11, 2007.

Ralf Krüger: Impact of high oil prices on oil-importing countries in Africa [*.pdf], UNECA
Project LINK meeting, Fall 2006, Geneva.

African Development Bank Group: Can Struggling African Economies Survive Escalating Oil Prices?

African Development Bank Group: High Oil Prices and the African Economy [*.doc] - Concept paper prepared for the 2006 African Development Bank Annual Meetings Ouagadougou, Burkina Faso.