Faculty of Economic Sciences, Communication and IT Leyth Al-Ameri OIL AND THE MACROECONOMY Empirical evidence from 10 OECD countries Economics Master´s Thesis Semester: Spring 2012 Instructor: Karl-Markus Modén Karlstads universitet 651 88 Karlstad Tfn 054 -700 10 00i Fax 054 -700 14 60 ”…Now oil prices and many broader indices of commodity prices are again at or near all-time highs in nominal terms, and are very high in real terms as well. Copper, platinum, nickel, zinc and lead, for example, all hit record highs in 2006, in addition to crude oil. As a result, commodities are once again hot. It turns out that mankind has to live in the physical world after all!...” Jeffrey Frankel, 2006 i Abstract This paper examines the oil price-macro economy relationship by means of analyzing the impact of oil price on Industrial production, real effective exchange rate, real long term interest rate and inflation rate for a sample of ten OECD countries using quarterly data for the period 1970q1-2011q1. The impact of oil price shock on industrial production is negative and occurs with a lag of one year. However, the impact has weakened considerably compared to the 1970s. The impact on real effective exchange rate is negative/positive for a net importer/exporter, and the magnitude of the shock depends on the county´s share of net import/export of total world demand/supply. Real interest rates are affected negatively, through increase in inflation rates following the oil price shock. The effect tends to die out after 5-8 quarters following the shock for most of the variables and countries. This paper also applies alternative methods to test for unit root and cointegration, which takes into account for structural breaks in the data. The weakness of Phillips-Peron test is clearly demonstrated in the case of inflation rates and real interest rates, where the test falsely considered the series to be non-stationary when they in fact are stationary around a structural break. There is also strong evidence of cointegration between oil price and inflation rates and between oil price and real interest rates, especially when taking account for structural breaks. This study also highlights the relevance of oil scarcity and oil peak theory. It is shown that these two terms should receive more attention than they have received so far as more oil exporters have reached their production peaks and more are likely to be followed. Oil scarcity seems not to be reflected in the price of oil, this in turn will increase the risk for the search for alternatives being initiated too late. Scarcity could then pose a serious limitation to the economy before a substitute resource or technology has been found. According to the data, renewable source of energy are not likely to dominate OECD countries energy mix in the short term, instead, there is a trend of increasing natural gas consumption among most of OECD countries. Natural gas markets are likely to play an equal role in the future as oil markets do today. The dilemma that importing countries are facing today, particularly in Europe, is whether to expose their markets to Russia or to the Middle East. ii Table of contents Chapter 1: Introduction ......................................................................................................................1 Chapter 2: Non-renewable natural resources ......................................................................................5 2.1 The importance of oil for oil-importing OECD countries .............................................................5 2.2 Oil Scarcity ................................................................................................................................9 2.3 Why do oil prices not increase in the long-term? ..................................................................... 11 Chapter 3: Some words on the relationship between oil prices and macroeconomic variables .......... 13 3.1 Oil price and Industrial production .......................................................................................... 13 3.2 Oil price and real effective exchange rates .............................................................................. 14 3.3 Oil price and real long term interest rates ............................................................................... 16 3.4 Oil price and Inflation rates ..................................................................................................... 17 Chapter 4: Literature review ............................................................................................................. 19 Chapter 5: Methodology ................................................................................................................... 23 5.1 Source of data and information ............................................................................................... 23 5.2 The way the variables are used................................................................................................ 23 5.3 Empirical Models ..................................................................................................................... 24 5.3.1 Correlations ...................................................................................................................... 24 5.3.2 Oil shock´s contribution to industrial production .............................................................. 24 5.3.3 Unit Root tests.................................................................................................................. 25 5.3.4 Cointegration tests ........................................................................................................... 26 5.3.5 Vector Autoregressions .................................................................................................... 27 5.3.6 Hubbert peak theory ........................................................................................................ 29 Chapter 6: Empirical analysis............................................................................................................. 31 6.1 The macroeconomic relationship............................................................................................. 31 6.1.1 Correlations ...................................................................................................................... 31 6.1.2 Oil shock´s contribution to industrial production .............................................................. 32 6.1.3 Unit Root tests.................................................................................................................. 32 6.1.4 Cointegration tests ........................................................................................................... 33 6.1.5 Selecting lag order for VAR model .................................................................................... 34 6.1.6 Granger causality .............................................................................................................. 34 6.1.7 Impulse response analysis ................................................................................................ 35 6.1.8 Variance decomposition analysis ...................................................................................... 36 6.2 Oil Consumption and Economic growth ................................................................................... 37 6.3 Depletion analysis ................................................................................................................... 39 Chapter 7: Conclusions ..................................................................................................................... 42 References ........................................................................................................................................ 45 Appendices ....................................................................................................................................... 48 A1. Data ........................................................................................................................................ 48 A2. Correlations ............................................................................................................................ 50 A3. Oil Shocks contribution to Industrial production...................................................................... 51 A4. Unit Root tests ........................................................................................................................ 52 A5. Cointegration tests .................................................................................................................. 54 A6. Lag order selection criteria ...................................................................................................... 56 A7. Granger Causality .................................................................................................................... 56 A8. Impulse Response ................................................................................................................... 57 A9. Variance decomposition.......................................................................................................... 62 A10. Oil Consumption and Economic growth ................................................................................. 63 A11. Countries Energy Mix ............................................................................................................ 67 A12. Hubbert Linearization...........................................................................................................