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FEATURE STORY

Volatile Oil Prices Subject of Forum

March 10, 2008


STORY HIGHLIGHTS
  • Growing demand in emerging markets is the driver.
  • 'Tremendous potential' to increase supply.
  • Developing countries look for ways to smooth bumps in market.

March 10, 2008—A year ago, a barrel of oil cost about half of what it does today. The price of West Texas Intermediate surged from near US$50 a barrel in early 2007 to an all-time high of US$105 last week.

So are oil prices heading towards $150-or downward toward $50?

That's the key question at a forum this week on oil prices and how to cope with them.

More than 140 policy-makers from central banks, energy and finance ministries, oil company executives, representatives of heavy industrial users of oil, as well as economists and journalists, are in Washington for "Oil Price Volatility, Economic Impact, and Financial Management," co-sponsored by the World Bank Institute (WBI)  and The George Washington University.

The forum addresses an increasingly serious issue: the instability of the price of oil.

'Volatility Is Worsening'

Oil prices aren't just rising, "but the volatility is also worsening-fluctuations are more pronounced than they were in the 1990s," says WBI Senior Economist Yan Wang, the task manager of the forum.

"Unlike the previous oil shocks which were largely supply induced, price hikes this time 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."

The price of oil has escalated much more than expected. "It's caught most by surprise," says World Bank Senior Energy Economist Shane Streifel, a panelist at the forum's session on whether high and volatile prices are here to stay.

That's happened even though oil stocks around the world are not "critically low," and oil output by the Organization of the Petroleum Exporting Countries (OPEC) has recently edged higher.

Streifel says the oil boom of the last few years has been driven by a combination of factors: the loss of oil surplus capacity, "moderate" demand growth worldwide, with developing countries, especially in Asia, offsetting falling demand in OECD countries; disappointment that non-OPEC supplies have not increased in larger quantities; rising costs; and OPEC's cuts in production-most recently by 1.5 million barrels in 2006 and 2007.

Investors Shift to Commodities Over Stocks, Bonds

Other factors include a lower dollar, concerns about inflation, and investors turning to commodities and away from stocks and bonds.

OPEC has "tremendous potential" to increase supply, says Streifel. In addition, non-conventional oil sources such as Canada's oil sands, coal-to liquids and gas-to-liquids technology are expected to enter the oil pool, but will remain relatively small sources over the next decade.

While a lot of volatility is still expected, "resource-wise, there's plenty of oil that could come on stream. It is projected these prices will fall down to what would be the highest cost sources of supply - which today are the oil sands in Canada-to about $60-65 per barrel by 2015."

But current high and volatile prices are making it harder for oil importers to budget for energy costs. Volatility has also hurt economic growth, investment and trade, and several developing countries have lost ground in the poverty fight as a result. The Philippines last week said 4 million people slid back into poverty in 2006 as a result 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.

Robert Bacon, a consultant with the Oil, Gas and Mining Policy Division of the World Bank and former lead energy economist and manager of the division, says volatile oil prices have put pressures on developing countries to look for ways to smooth out the bumps in the market.

His 2006 study, "Coping with Higher Oil Prices," co-authored with Lead Energy Specialist Masami Kojima, looked at the experience of 38 developing countries that tried various ways of doing this.

Chile, Malaysia, Thailand, Indonesia and others used "price-smoothing," in which a country sets a target oil price. The government subsidizes oil if the international price goes above the target, and imposes taxes if it goes below.

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

Another technique is "hedging" - using financial instruments such as futures and options and "collars" which could mitigate price risks at a cost. Hedging, rarely used by governments but often by companies, requires a high amount of expertise and could backfire if the internal control and governance structure is not in place, says Bacon.

However, Ivan Zelenko, the head of derivatives in the World Bank Treasury, says "derivatives are the best way to transfer oil price risk to markets, provided they are used with a sound governance and trading platform Derivatives are very effective to mitigate oil price risk in the near/medium term (5 - 7 year horizon). Over the longer term, however, other solutions (like oil wealth funds) can be used."

The Forum will explore pros and cons of various hedging instruments that are available for managing oil price risks.

Energy Shift Could Bring More Pollution

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 (ethanol and bio-diesel) 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. Unfortunately, energy switching is often from oil to much cheaper coal in developing countries in East Asia, worsening the environmental picture, observes Bacon.

"It's very much lower, on a thermal efficiency basis. So we've got an environmental catastrophe racing faster at us…you've got poverty versus environment writ really large there."

"Oil is a necessity at the moment," adds Streifel. "Hydrogen cells might come, but it will not be anytime soon. And there is not an easy alternative to transport fuels."

Developing countries are therefore confronted with tough challenges in the short and medium term to maintain their growth momentum in a highly volatile environment, concludes Wang.

Oil Price’s Effects on Developing Countries

World Bank Managing Director Graeme Wheeler delivered the keynote speech at the Global Finance Forum on Oil Price Volatility, Economic Impacts and Financial Management, held in Washington March 10 and 11. Below is an excerpt pertaining to the impact of high energy prices on the poor.

"One of the cruel ironies today is the connection between rising energy and food prices. This coupling can have devastating implications for global poverty and food security. Higher energy prices have increased fertilizer 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 this year. Together, higher energy prices, drought, and rising demand have led to a 75 percent increase in the price of staples since 2005. Just last week, rice prices soared to 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. 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 globalization 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. The benefits of globalization are by-passing many of the poorest who 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 India.

"A world where a large proportion of the population remains trapped in extreme poverty and unable to share the benefits and opportunities of globalization, 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."

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