Master Thesis
entitled
“Effects of oil price fluctuations on real
exchange rate volatility and
uncertainty”
by
Jamila Mammadova
University of Amsterdam, Amsterdam Business School
MSc Business Economics, Finance track
Abstract
In my thesis I investigate the effect of crude oil price changes on national currencies across countries that significantly depend on crude oil revenues. Mainly these countries are OPEC countries as well as other emerging markets. Results of this research suggest a strong negative relationship between crude oil prices and currency fluctuations. Crude oil shocks inevitably are reflected in currency devaluations though total foreign reserves, current account balances, result in recession and fluctuations in inflation for 12 countries examined in my selected sample.
Keywords: Crude oil, Currency exchange rates, Crude oil exporters, National Budget, Breakeven prices, Cost of crude oil production.
Statement of originality
This document is written by Jamila Mammadova, who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Table of Contents
1. Introduction 5
2. Literature review and news update 11
2.1 Theoretical background 11
2.2 Mechanisms of crude oil hock transmission to exchange rates 12
2.3 Reasons of fluctuations 16
3. Hypothesis 17
4. Methodology 18
4.1. Data and descriptive statistics 18
4.2 Empirical results 20
5. Conclusion 24
5.1. Discussion 24
5.2. Costs of production and Fiscal break-even prices 26
References 28
1. Introduction
Modern economic history has evidenced a sharp decline in crude oil prices that started in June 2014. The decline resulted in a monthly average price per barrel of 47 USD, which quantifies to more than 50% of its original value. Extended price fall is infrequent in the market for crude oil. Prior to 2014 oil shock, a steep decrease was observed during 2008 financial crisis (see Graph 1.1 for recent crude oil prices drop and Graph 1.2 for 20 year historical spot prices).
Graph 1.2: Recent crude oil shock - Brent1 Light Crude oil (LCO)
Graph 1.1: Historical spot prices of crude oil
Declining prices of this particular energy commodity has built grounds of harsh
1 Brent crude oil is a light and sweet type of oil characterized as one of the benchmarks in oil pricing. This type
of oil is considered to be light due to very little density and small amounts of sulfur in its content. Denotation of “Brent crude” is derived from Brent oilfield, which is located in the water basin of the North Sea, nearby the shores of Scotland. This oilfield was initially discovered in 1971 by the major oil exploring company Shell. Brent Crude is also referred as Northwest-European as it is being extracted mainly from the Northern Sea. Other oil pricing benchmarks include West-Texas Intermediate (WTI), Dubai Crude, Oman Crude, Ural Oil etc. The empirical analysis of my research is based on Brent Light Crude Oil (LCO) benchmark.
economic conditions among oil exporters across the globe. It has also put pressure on the financial stability in countries that heavily depend on foreign exchange dominated revenues. At the same time, oil importers have profited from reduced oil prices. Renewable and alternative sources of energy have started gaining popularity since the drop in commodity prices. Coupled with the commitment to diminish greenhouse gas (GHG) and carbon dioxide emissions (CO2)2, a number of countries have become leaders in renewable energy solutions. Currently Sweden is striving to reach the target of 100% withdrawal from fossil fuel usage and shift towards alternative sources of energy. Due to favorable geographic location, Costa Rica intends to meet 100% energy needs from solar, hydro, wind and low-carbon sources by 2021. Countries that lead the list of “clean energy sources”3 include UK, US as well as Scotland and Germany (EcoWatch 2016, CleanTechnica 2016).
There are a number of reasons that have provoked the decline in crude oil prices in the middle of 2014 that haven’t been predictable by industry experts. According to the study conducted by Baumeister and Kilian (2012), Alquist, Kilian and Vigfusson (2013) that was based on the economic principles, only half of cumulative price drop was anticipated before June 2014 using the publicly available information and more than half of price drop was anticipated after June 2014. Major shocks in prices were observed in July 2014 and December 2014. The VAR model implemented by Baumeister and Kilian (2016), present evidence that July 2014 shock is correlated with low demand for crude oil from Europe as well as from Asia. Weak demand for the energy commodity in Asia was caused by the downfall of Abenomics 4 in Japan prior to elections in November 2014 and economic stagnation of China. Low demand from Europe was caused by debates regarding Greek exit (Grexit5) from euro zone, negative economic outlook and anxiety over sanctions against
2Main sources of carbon dioxide emissions (CO
2)2 come from burning of crude oil, gas, coal and deforestation.
3 Clean energy sources include sources that do not cause pollution in the atmosphere when utilized. Also referred as alternative energy and renewable energy. Renewable energy produce very small volume of greenhouse gas emissions when operated, rather than crude oil, coal or gas that warm the atmosphere and cause global warming and climate changes. Greenhouse gas soaks in and irradiates radiation often referred as “greenhouse effect”. Scientists report that if greenhouse gas emissions persist at current rates, the surface of the planet might surpass recorder values with possibly adverse effects on the entire ecosystem. Examples of clean energy sources are solar, geothermal, wind, hydroelectricity, which currently gains more popularity worldwide.
4 Abenomics is a set of economic policies in Japan, which consists of monetary, fiscal and economic development strategies to stimulate private investments across Japan.
5 An economist Rahbari E. introduced “Grexit” term from CitiBank in early 2012 as a potential solution for Greek government to deal with its public debt. According to recent news, many industry experts believe that the exit is inevitable.
Russia that started in the middle of 2014. December 2014 shock is correlated with OPEC6 agreement not to reduce oil production and increase of crude oil supply in the market. Details on the causes of crude oil price drop are presented in details in the literature review and news update section of this thesis.
The more a particular country is dependent on a crude oil, the stronger is the correlation between the national currency of that country and crude oil prices. Miscellaneous studies have examined the relationship of crude oil prices and exchange rates. Empirical evidence and research results suggest that crude oil shocks considerably affect terms of trade and thus economy’s competitiveness. The influence of oil shocks depend if the country is a net importer or a net exporter of this crude oil. Basher, Haug and Sadorsky (2016) detected exchange rate appreciation difficulties in oil exporter countries in times of oil shocks. Globally, oil shocks influence both exporting and importing sovereign states, although results do not suggest any particular standardized pattern of appreciating or depreciating of a national currency against the pegged7 currency (usually USD, EUR or GBP).
In my research, I analyze crude oil and foreign exchange relationship across countries that heavily depend on crude oil sales. Graph 1.1 illustrates countries based on the crude oil dependence. Particularly, I focus on sovereign states in which crude oil exports account more than 20% of total GDP.
6 OPEC (The Organization of Petroleum Exporting Countries) members include: Algeria, Angola, Ecuador, Gabon, Indonesia, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, United Arab Emirates, Venezuela.
7 Pegged exchange rate (also referred as “fixed”) is an exchange rate policy of assigning the Central Bank’s exchange rate to a foreign currency. This exchange rate policy balances exchange rates between countries and permits predictability in both short and long-run horizons for trading participants, financial institutions and intermediaries. Previously, during Gold Standard exchange rates were identified in terms of gold. In the middle of XX century most countries terminated the gold standard monetary system and adopted either pegged exchange rate or floating exchange rate (The Bretton Woods system). Most often currencies are pegged to USD or EUR. Furthermore, the selection of the currency
Graph 1.1: Countries with the highest oil dependence
Source: The Global Economy (2016), World Bank (2016). Based on 2014 data
As the graph illustrates, most crude oil dependent economies are located in Middle East and Africa. I center my empirical analysis on economies tin which oil and energy industry contributes to the GDP by at least 20%. My sample includes data from 12 most heavily oil dependent countries: 5 Middle Eastern countries, 4 African countries, 2 countries from former Soviet Union territory and 1 South American country. Time period captured in my sample is starting from 1996 till 2015. Table 1.1 summarizes the selected countries in the sample and provides the percentage of crude oil contribution to the GDP. Graph 1.2 illustrates the percentage comparatively. The data is based on 2014 fiscal year. The reason for this is that crude oil shocks started in 2014.
Table 1.1: Countries with the highest crude oil dependence
No. Country Crude oil as a
percentage of GDP Geographical region
1 Kuwait 53.04 Middle East
2 Republic of Congo 45.17 Africa
3 Equatorial Guinea 42.74 Africa
4 Iraq 41.36 Middle East
5 Saudi Arabia 38.71 Middle East
6 Azerbaijan 27.23 Former USSR region
7 Iran 23.65 Middle East
8 Venezuela 22.03 South America
9 Kazakhstan 20.99 Former USSR region
10 Libya 33.28 Africa
11 Gabon 34.74 Africa
12 Oman 27.97 Middle East
Source: The Global Economy (2016), World Bank (2016). Based on 2014 data.
Graph 1.2: Crude oil as a percentage of total GDP
Source: The Global Economy (2016), World Bank (2016). Based on 2014 data.
Crude oil shock that started in 2014 was unpredictable for a number of industry experts and analysts. Thus, it is essential to analyze how oil price volatility influences financial
markets, in particular, how it affects exchange rates. The ultimate research question of this thesis is:
“To what extent oil price fluctuations lead to exchange rate volatility and uncertainty?” Table 1.2 provides an overview of ISO 4217 Currency Codes, which was introduced by the ISO Technical Committee in 1973 with the main objective to establish national codes as a representation of national currencies that would facilitate international trade and transactions.
Table 1.2: Crude oil dependent countries and national currencies
No. Country ISO 4217 Currency Codes Trading Terminology
1 Kuwait KWD Kuwaiti Dinar
2 Republic of Congo CDF Congolese Franc
3 Equatorial Guinea XAF Central African Franc
4 Iraq IQD Iraqi Dinar
5 Saudi Arabia SAR Saudi Arabian Riyal
6 Azerbaijan AZN Azerbaijani New Manat
7 Iran IRR Iranian Rial
8 Venezuela VEF Venezuelan Bolivar
9 Kazakhstan KZT Kazakhstani Tenge
10 Libya LYD Libyan Dinar
11 Gabon XAF Central African Franc
12 Oman OMR Omani Rial
2. Literature review and News update
2.1. Theoretical background
Domestic economies comprise of two various sectors: production of exportable one producing an exportable good, named “primary goods” and production of non-traded goods. Focus of this research is entirely on the most traded exportable goods from all commodity categories – crude oil. Cashin and Ce´spedes (2004) from the research department of International Monetary Fund examined if foreign exchange rates in exporting economies change accordingly with prices of 44 commodities between years 1980 and 2002 across 58 countries. Outcomes of the research indicate an long-term commodity-forex correlation only for one-third of commodity exporting economies. Various academic studies have analyzed the relationship between crude oil and exchange rates mainly by using three different types of econometric methods: cointegration8 technique, Granger-causality9 tests and vector autoregression (VAR)10 models. Amano and Norden (1998) find an empirical evidence supporting the cointegration existence between crude oil prices and USD exchange rates between years 1972-1993. Benassy et al. (2007) affirms Granger-causality between oil price and exchange rates by showing the appreciation of USD in times of oil price rise in the long-term. Nevertheless, results also indicate that from 2002 and 2004 USD depreciated, while crude oil prices enhanced. Sadorsky (2000) explored linear vector autoregression models and associated Granger causality for the prediction of future oil prices. Results are in favor of cointegration and rates convey exogenous shocks to crude oil long-run prices between years 1987 and 1997.
Furthermore, Reboredo (2012) analyses linear as well as non-linear correlation with the use of copula functions to observe symmetric, asymmetric and time-varying changes between oil prices and exchange rates pegged to USD among oil exporting / importing markets for the time period 2000 to 2010. The correlation between variables was detected to be weak specifically in oil importing countries. However, after the global financial crisis in 2008, the correlation was observed to be higher. Akram (2009) used VAR model and his results suggest
8 Cointegration - econometric method for analyzing the relationship between non-stationary time series variables. In case two or more series contain a unit root, then series are cointegrated.
9 Granger causality tests - tests of causality based on forecasts. It determines if one time series is applicable in forecasting another time series. For instance if X is a signal for Y, then X includes information and signals that assists in forecasting Y.
10 Vector autoregression (VAR) models - models that captures linear dependencies between time series variables. VAR modeling depicts the progression of variables based on lagged values.
that depreciated USD generates higher crude oil prices between 1990-2007. Fratzscher et al. (2014) applied VAR model including USD rates and proxies for financialization of the market. Research results discover causality between USD and prices starting from 2000 and a strong negative correlation between oil prices and USD since that period of time.
A new approach by applying Markov-switching method11 was analyzed by Basher et al. (2016). The study captured real exchange rate deviations for Canada, Norway, UK, Brazil, Mexico, Russia, India, Japan and South Korea. Regressions of real exchange rates on crude oil prices, aggregate oil supply and aggregate oil demand illustrate nonlinearity for both oil exporting and importing markets. Oil prices were found to have statistically significant effect on the rates almost in all countries in the sample, thus providing a clear indication of energy prices shock on currencies. Furthermore, oil exporting markets experience statistically significant strain in oil demand shocks, whereas oil importing economies do not illustrate a clear proof in times of oil supply shocks.
2.2. Mechanisms of crude oil shock transmission to exchange rates
Volatility in crude oil prices has been consistent with volatility in exchange rates over the last decade. The most prominent illustration of this is the strong negative link between crude oil prices and USD exchange rates since 2000s, while there hasn’t been a standardized pattern in co-movements during previous several decades (Fratzscher, 2014). Crude oil as a financial asset instantly portrays information with regards to other assets, which wasn’t present previously. According to a recent study conducted by the European Central Bank in 2014, a day-to-day effect of crude oil on exchange rates vanishes if data prior 2001 is analyzed. This phenomenon can be explained by the fact that crude oil has become used as a financial asset over the last decade; in other words, crude oil market has experienced financialisation. One of the key points from the Nations Conference on Trade and Development Industry that took place in September 2012, is that the reason of crude oil price volatility is the financialisation of the energy markets. The suppressing demand and growth for exchange-traded derivatives on commodity markets are more than 20 times more than actual production and the impact of financial markets has converted real oil markets in financial markets (UNCTAD, 2016). Financialisation of the market for crude oil is caused by
11 Markov-switching method assumes deviating causality rather than linear models with fixed parameters and no variation. Linear model estimations are usually not entirely plausible because there might be breaks in the sample. Markov-switching method supposes larger sample with more observations that can also include outliers. This method contains non-linearity and/or asymmetry.
a considerable growth in a wide range of tools allowing industry experts and portfolio investors to speculate, hedge and arbitrage in oil. Examples include derivatives trading (futures, options) and FOREX funds. Graph 2.2.1 presents a clear evidence regarding the financialisation of crude oil over the last years. According to the graph, the spot price of crude oil has traced an identical movement with non-commercial long-positions of crude oil futures in early 2000s. During global financial crisis in 2008 there has been an interim stagnation in oil financialisation due to global financial distress. Numerous analysts have stated that a significant increase in financial involvement have caused crude oil prices volatility coupled with aggregate crude oil supply and demand. Academic theory forecasts a restricted capacity of crude oil financialisation in the long-run prospects (VOX, 2016). Nowadays, price fluctuations in oil lead to growing concern among policy circles.
Graph 2.2.1: Financialisation of crude oil in 2000s
Source: VOX, CERP’s Research Portal (2016).
In general, rise in crude oil leads to an appreciation of currencies in oil exporting countries. Currencies in these countries that follow this trend are often referred as “oil currencies”. From the financial markets perspective, there are two mechanisms explaining the transition of crude oil shocks on exchange rate shocks. Transfer of shocks from crude oil to exchange rate can occur both directly and indirectly.
The first channel is the terms of trade, which affects exchange rates of both oil exporting and importing countries. A term of trade (TOT) is a ratio of export to import prices. It estimates the quantity of imports a domestic economy can get for one unit of an exported good. For instance, if Kuwait exports only crude oil and imports only German cars, then terms of trade for Kuwaiti economy is the price of crude oil divided by the price of cars. Terms of trade measure gives an estimation of how many German cars a Kuwaiti economy can get for a barrel of crude oil. In other words, terms of trade is the ratio of net import deflator over net export deflator in national revenues. A study conducted by Backus and Crucini (2000) illustrate that changes in crude oil prices is one of the main explanatory factors of the modifications in terms of trade for a number of countries. For instance an increase in oil prices leads to a deterioration of trade balances (income shock) across oil importing countries and depreciation of the national currencies (Fratzscher et al, 2014). Similarly, a decrease in oil prices results in a slump of trade balances (income shock) among oil exporting economies and depreciation of local currencies. In order to guarantee external financial stability inflation adjusted exchange rates of the country experiencing income shocks requires to depreciate to correct the non-oil trade balance. Positive terms of trade shocks in oil exporting economies increases prices of non-traded goods in the national economy and inflation adjusted real exchange rates, also called as “Dutch Disease”. Hence, currency appreciation due to high oil prices may lead to a decline of a manufacturing sector. Negative terms of trade decrease prices of non-traded goods and real exchange rates, which is determined as a price of a basket of both traded and non-traded goods between domestic and foreign markets. This market movement is in line with Balassa-Samuelson effect12, which
was introduced in 1963. In accordance with Cashin et al (2004), Chen and Rogoff (2003) prices of traded goods are usually fixed in the markets, which allow sovereigns to define domestic revenues from both traded as well as non-traded goods. Arezki and Hasanov (2007) emphasize a crucial role oil exporters play in global account disparity and assert that crude oil prices together with fiscal policies are main determinants of current account fluctuations. With regards to foreign exchange reserves - the lower is the degree of foreign exchange flexibility, the higher is the difficulty decreasing on foreign exchange reserves (Buetzer, 2012). Furthermore, investments made by sovereign wealth funds play a critical role in
12 Balassa-Samuelson effect implies that inflation rate in emerging markets is higher than in developed
economies. Developed markets experience high wages that brings to high exchange rates. This effect indicates that income growth from tradable goods industry in a developing economy will cause higher wages from non-tradable sector. Higher inflation in developing economies Balassa-Samuelson effect also implies that the influence of an appreciating real exchange rate in a developing market relies whether the exchange rate is fixed or floating.
account balances. A report conducted by McKinsey in 2007 underlines a movement of reserve assets from national banks to sovereign wealth funds in a number of countries over the last years. Sovereign wealth funds have become active investors due to strong interest in long-run return on investments.
The second mechanism though which oil shocks transfers to exchange rates shocks is
wealth effect. This channel of transmission implies that high oil prices are connected to
wealth shifts from oil importers to oil exporters and results in real exchange rate appreciation for oil exporters and real exchange rate depreciation for oil importers economies. The shift is also associated with account balances and portfolio relocations. (Buetzer et al., 2012; Fratzscher et al., 2014). Krugman and Golub (1983) introduced empirical evidence illustrating the shift by using two oil importer countries and one oil exporter countries in the analysis. Research outcome demonstrate that increase in crude oil prices leads to current account imbalances, capital flows, portfolio relocations, and eventual transfer of wealth to oil exporting economy. Ultimately, changes in current accounts result in modifications in exchange rates. Graph 2.2.2 and Graph 2.2.3 depict detailed steps of two mechanisms of crude oil shock transmission to exchange rates.
Graph 2.2.2: The terms of trade
Crude oil trade shock Income shock
Deterioration of trade balances Decline in prices of non-tradable goods in the domestic economy
Adjustment of exchange rates to recover financial stability
Graph 2.1.2: Wealth effect
2.3 Reasons of fluctuations
Fluctuations of crude oil prices have been one of the most observed trends among economists in the past decades. From 2000 till 2008 crude oil prices evidenced a sharp increase from almost 20 USD per barrel up to 148 USD. Growing demand from the emerging markets such as China and India and slowdown in crude oil production by OPEC member countries led to increase of oil prices during this time period. After the global financial crisis the demand for crude oil has decreased significantly, which drove crude oil prices to fall till 39 USD per barrel. The restoration in prices was observed by 2009 when prices reached 110 USD per barrel. In the middle of 2014 prices started to drop considerably. This was due to a number of factors including:
• The slowdown of Chinese economy, which used to create large demand for crude oil in the previous decades;
• The increased production of crude oil by the US and Canada, which resulted in oversupply of oil in the market. Oil companies in these markets started oil production using a new method named “Fracking”;
• Stable ongoing production of oil by Saudi Arabia, which aims to keep its large market share of oil production in the energy industry and views this strategy as one of the most important for a long-term perspective.
Crude oil trade shock Income shock
Transfer ot wealth from exporters to importers
Shifts in current account balances Adjustment of exchange rates to recover financial stability
Crude oil prices were observed to be stable in early 2014 due to continued large supply disruptions, but fell sharply later in the year due to strong non-OPEC production growth combined with weaker consumption growth. The differential between Brent and the US benchmark West Texas Intermediate (WTI) narrowed to 5.66 USD per barrel despite continued robust US production growth. The consequences of crude oil price decline include:
•
Collapsing revenues could bring political instability to fragile parts of the world, such as Venezuela and the Gulf, and fuel rivalries in the Middle East;•
Cheap oil reduces the incentive to act on climate change. Most worrying of all is the corrosive new economics of oil;•
Adjusting revenue and government spending policies by a number of oil dependent countries, introduction and implementation of fiscal reforms;•
Lower credit ratings due to constrained budgets (CNBC, 2016).3. Hypothesis
Hypothesis 1: Crude oil price decrease has a negative effect on national
currencies in dependent economies and thus leads to currency depreciation.
This hypothesis has the goal of revealing empirical evidence based on financial and macroeconomic variables. Variables that I include in my analysis are based on two mechanisms that lead crude oil price shocks to national currency shocks: terms of trade effect and wealth effect. Namely, I analyze the dependence the co-movement in changes between crude oil and changes in currency exchange rates based on total foreign reserves, current account balance and inflation. I also intend to add GDP growth as a measure to evaluate the co-movement in currency exchange rates and crude oil prices. This is one of the differences of my analysis from the vast majority of research with regards to this area of economics and finance. The OLS specification is the following:Change in exchange ratet= β0+ β1*Change in Crude Oil Price t + β2* Foreign Reserves t + β3*Current Account Balance t + β4* GDP growth t + β5* Inflation ε
4. Methodology
4.1 Data and descriptive statistics
Empirical research is focused on changes in crude oil prices explained by changes in currency exchange rates, total foreign reserves hold under control of sovereigns, current account balance of the national budget, annual GDP growth and inflation rates for 12 countries including Kuwait, Republic of Congo, Equatorial Guinea, Iraq, Saudi Arabia, Azerbaijan, Iran, Venezuela, Kazakhstan, Libya, Gabon and Oman. The time period in the sample is from January 1996 until December 2015. The frequency of the data is daily. The econometrics method used is panel data research, as opposed to cointegration technique, Granger-causality tests and vector autoregression in previous studies. Table 4.1.1 shows descriptive and summary statistics for the variables of interest for 12 highly dependent crude oil economics.
Table 4.1.1: Summary statistics
Variable Observations Mean Std. Dev. Min Max
Change in oil prices 5,219 -0.003 1.326 -18.560 14.760
Change in currency - Kuwait 5,219 0.000 0.001 -0.017 0.018
Foreign Reserves - Kuwait 5,219 9.803 5.410 1.000 19.000
Current Account Balance - Kuwait 5,219 10.502 5.767 1.000 20.000
GDP growth - Kuwait 5,219 3.670 5.465 -7.076 17.320
Inflation - Kuwait 5,219 3.147 2.273 0.130 10.583
Change in currency - Republic of Congo 2,965 -0.174 44.048 -905.830 912.000
Foreign Reserves - Republic of Congo 5,219 9.503 4.555 1.000 15.000
Current Account Balance - Republic of Congo 5,219 7.350 2.780 1.000 11.000
GDP growth - Republic of Congo 5,219 3.301 4.868 -6.911 8.969
Inflation - Republic of Congo 5,219 3.147 2.273 0.130 10.583
Change in currency - Equatorial Guinea 5,219 0.000 5.752 -98.290 101.420
Foreign Reserves - Equatorial Guinea 5,219 9.250 4.381 1.000 14.000
Current Account Balance - Equatorial Guinea 5,219 8.753 5.412 1.000 18.000
GDP growth - Equatorial Guinea 5,219 2.826 1.598 -0.280 5.182
Inflation - Equatorial Guinea 5,219 4.045 3.445 -0.882 10.031
Change in currency - Iraq 5,219 -0.200 80.066 -2,260.720 2,261.120
Foreign Reserves - Iraq 5,219 7.902 3.175 1.000 12.000
Current Account Balance - Iraq 5,219 3.650 2.287 1.000 9.000
GDP growth - Iraq 5,219 8.239 16.408 -33.101 54.158
Variable Observations Mean Std. Dev. Min Max
Change in currency - Saudi Arabia 5,219 0.000 0.004 -0.073 0.074
Foreign Reserves - Saudi Arabia 5,219 10.501 5.767 1.000 20.000
Current Account Balance - Saudi Arabia 5,219 10.498 5.766 1.000 20.000
GDP growth - Saudi Arabia 5,219 4.475 2.933 -0.748 9.959
Inflation - Saudi Arabia 5,219 12.632 15.949 -16.117 53.231
Change in currency - Azerbaijan 2,507 0.000 0.004 -0.159 0.040
Foreign Reserves - Azerbaijan 5,219 10.501 5.766 1.000 20.000
Current Account Balance - Azerbaijan 5,219 10.497 5.765 1.000 20.000
GDP growth - Azerbaijan 5,219 9.975 8.786 0.066 34.500
Inflation - Azerbaijan 5,219 2.147 2.788 -1.348 9.869
Change in currency - Iran 5,219 638.644 253.189 1.000 1,274.000
Foreign Reserves - Iran 0
Current Account Balance - Iran 5,219 2.250 0.830 1.000 5.000
GDP growth - Iran 5,219 3.691 3.596 -6.609 9.116
Inflation - Iran 5,219 5.432 6.885 -8.525 20.792
Change in currency - Venezuela 2,088 -0.002 0.162 -3.090 3.090
Foreign Reserves - Venezuela 5,219 10.499 5.767 1.000 20.000
Current Account Balance - Venezuela 5,219 10.503 5.769 1.000 20.000
GDP growth - Venezuela 5,219 2.016 6.758 -8.856 18.287
Inflation - Venezuela 5,219 18.280 6.966 10.137 39.266
Change in currency - Kazakhstan 5,039 -0.023 1.575 -28.139 28.194
Foreign Reserves - Kazakhstan 5,219 10.498 5.768 1.000 20.000
Current Account Balance - Kazakhstan 5,219 10.353 5.552 1.000 19.000
GDP growth - Kazakhstan 5,219 5.947 4.107 -1.900 13.500
Inflation - Kazakhstan 5,219 36.023 27.877 12.535 121.738
Change in currency - Libya 5,155 0.000 0.012 -0.436 0.278
Foreign Reserves - Libya 5,219 9.753 4.888 1.000 17.000
Current Account Balance - Libya 5,219 8.650 5.545 1.000 18.000
GDP growth - Libya 5,219 2.982 28.253 -62.076 104.487
Inflation - Libya 5,219 10.206 7.462 5.114 39.183
Change in currency - Gabon 5,219 0.000 5.752 -98.290 101.420
Foreign Reserves - Gabon 5,219 10.502 5.767 1.000 20.000
Current Account Balance - Gabon 5,219 4.253 2.387 1.000 10.000
GDP growth - Gabon 5,219 2.141 4.029 -8.933 7.092
Inflation - Gabon 5,219 2.170 5.542 -9.798 15.518
Change in currency - Oman 3,877 0.000 0.001 -0.017 0.017
Foreign Reserves - Oman 5,219 10.497 5.767 1.000 20.000
Current Account Balance - Oman 5,219 10.498 5.767 1.000 20.000
Change in oil prices is a daily change in crude oil prices from January 1, 1996 until
December 31, 2015. Change in currency is a daily change of national currencies against USD from January 1, 1996 until December 31, 2015. Foreign Reserves consist of precious metal gold, assets held by central bank, different bank reserves and assets deposited by the government, reserves hold at IMF, special drawing rights and reserves held under control of monetary authorities. Usually they are held in USD, especially if the national currency is pegged to the USD. The value of gold reserves is valued at year end (December 31) London prices. Current Account Balance is the sum of net exports of goods and services as well as net primary and secondary income. Both Foreign Reserves and Current Account Balance are measured in USD throughout my research. GDP growth is expressed in percentages and is an annual gross value added by all producers of the economy in addition to any product taxes. GDP growth is computed with no subtraction for depreciation of fabricated assets or deficiency of natural resources. I will use this variable to examine if fall in crude oil prices causes recession across selected countries. Inflation estimates the annual percentage change in the consumer price index that portrays the annual modification in the cost to the average consumer of purchasing a basket of goods as well as services. Data is derived from The World Bank and reflects time period from January 1, 1996 to December 31, 2016 for all variables.
4.2. Empirical results
This section presents the regression outputs and empirical results of the research. As explained previously in Hypothesis section, the goal of my analysis is to reveal if crude oil price decrease has a negative effect on national currencies of oil dependent economies and thus lead to currency depreciation. Regression output is illustrated in Table 5.1. According to my results, there is a negative correlation between changes in currencies and changes in crude oil prices for all 12 countries in the sample. Econometric interpretation of main dependent and independent variables is the following: if changes in national currency raises then changes in crude oil price will decrease by the coefficient number for the given countries. In practice the effect comes from changes in crude oil in the first place, which affects currencies and hence it would be worthwhile to mention that if change in crude oil prices rise, the change in currencies decrease and if change in crude oil fall then change in currencies increase. As expected, there is a negative link between crude oil prices and exchange rates in
crude oil dependent economies. This is also supported by numerous studies conducted regarding the relationship between these variables previously. Particularly, the co-movement in crude oil price changes and exchange rate changes is strong in Kuwait (coefficient = -25.922), Saudi Arabia (coefficient =-0.199), Azerbaijan (coefficient=-11.016) and Oman (coefficient=-12.230). The coefficient is the highest for Kuwait which proves the fact that Kuwait is the most dependent economy from the selected sample. 53.04% of its GDP is derived from crude oil. Coefficient -0.199 for Saudi Arabia illustrates weaker dependence on crude oil revenues and less exposure to price fluctuations than for Kuwait. Coefficient -11.016 for Azerbaijan depicts stronger vulnerability to the volatility in crude oil prices. Oman’s change in currency coefficient is equal to -12.230 and presumes more exposure for crude oil price fluctuations than for Saudi Arabia, even though the crude oil percentage of GDP is 27.97% compared to 38.71% for Saudi Arabia. It is worthwhile to mention the statistical significance of all coefficients except for Kuwait at 5% significance level.
Foreign reserves explanatory variable is very low and statistically insignificant with explaining changes in crude oil prices for Kuwait, Republic of Congo, Equatorial Guinea, Iraq and Libya. Nevertheless, it is statistically significant at 5% level for Saudi Arabia, Azerbaijan, Iran, Venezuela, Kazakhstan and Gabon. In Oman foreign reserves are significant at 1% level. Foreign reserves is positively correlated with changes in crude oil prices, which illustrates that increase in foreign reserves is associated with the rise in crude oil prices. The higher are the prices for crude oil, the more assets and gold reserves are going to be held by the governments in the foreign reserves. When prices for crude oil drop drastically, foreign reserves may dry up as these reserves are used for maintaining financial stability within the country and maintaining the national currency exchange rate levels.
Current account balance coefficients are slightly higher than foreign reserves for almost all countries with the exception of Equatorial Guinea, Libya and Oman. It is statistically significant at 1% for Saudi Arabia and at 5% for Iran, Venezuela, Libya, Gabon and Oman. Drop in crude oil prices means deterioration in trade balance and current account balance for the countries in the dataset. This also explains shrinking in current account balance in times when crude oil prices are low for oil exporting countries. At the same time crude oil drop leads to trade balance and current account balance improvements for crude oil importers (Europe for instance).
GDP growth explanatory variable is negatively correlated with crude oil price and is statistically significant at 5% level for Kuwait, Iraq, Azerbaijan, Iran, Kazakhstan and Gabon. This indicates that crude oil price drop significantly lowers GDP growth in these countries
and lowers levels of aggregate output. Regression output shows that fall in crude oil prices leads to recession in these countries in particular.
Inflation variable positively explains changes in crude oil prices and is statistically significant at 1% for Equatorial Guinea and at 5% for Iraq, Saudi Arabia, Iran, Kazakhstan, Libya and Oman. Such relationship between variables means that when crude oil prices rise inflation in these countries rise and when crude oil prices drop inflation in these countries drops. For the Republic of Congo the coefficient is negative equaling to -0.003 and statistically significant at 1%.
Table 5.1: Empirical Results
Note: *** Statistically significant at 1%; ** Statistically significant at 5%; * Statistically significant at 10% (standard errors given in parenthesis)
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)
Kuwait Republic of Congo Equatorial Guinea Iraq Saudi Arabia Azerbaijan Iran Venezuela Kazakhstan Libya Gabon Oman
Change in Kuwaiti Dinar Change in Congolese Franc Change in Central African Franc Change in Iraqi Dinar Change in Saudi Arabian Riyal Change in Azerbaijani New Manat
Change in Iranian Rial Change in Venezuelan Bolivar Change in Kazakhstani Tenge Change in Libyan Dinar Change in Central African Franc Change in Omani Rial
KWD/USD CDF/USD XAF/USD IQD/USD SAR/USD AZN/USD IRR/USD VEF/USD KZT/USD LYD/USD XAF/USD OMR/USD
Change in currency -25.922 `-0.001** `-0.001** `-0.001*** `-0.199** -11.016 `-0.001*** `0.088** `-0.006** `-0.682** `-0.001** `-12.230**
(21.413) (.002) (.003) `0.001 (4.955) (8.839) `0.001 (.246) (.012) (1.555) (.003) (19.658)
Foreign Reserves 0.004 0.022 0.0005 0.008 `0.002** `-0.015** `0.006** `0.010** `0.001** 0.007 `0.001** `-0.004***
(.003) (.013) (.005) (.006) (.004) (.016) (.015) (.014) (.004) (.004) (.003) (.004)
Current Account Balance 0.005 -0.024 -0.004 0.016 `-0.003*** -0.025 `-0.013** `0.012** 0.005 `-0.001** `-0.002** `0.002**
(.003) (.013) (.003) (.008) (.003) (.021) (.022) (.014) (.003) (.003) (.008) (.004) GDP growth `-0.001** 0.034 `0.011** `-0.001** `0.001** `-0.001** `-0.005** 0.026 `-0.002** `0.001** -0.007 `0.001** (.003) (.023) (.013) (.001) (.007) (.004) (.006) (.017) (.005) (.001) (.005) (.009) Inflation 0.010 `-0.003** `0.008*** `0.001** `0.001** 0.016 `0.001** 0.006 `0.002** `0.001** 0.022 `0.001** (.008) (.016) (.008) (.001) (.009) (.011) (.003) (.003) (.004) (.003) (.011) (.009) Constant -0.120 -0.205 `-0.041** -0.138 `-0.014** 0.414 0.124 -0.532 `-0.065** -0.066 `-0.036** `-0.001** (.065) (.175) (.065) (.069) (.058) (.329) (.092) (.361) (.08) (.064) (.049) (.085) N 5,219 2,965 5,219 5,219 5,219 2,507 5,219 2,088 5,039 5,155 5,219 3,877 Adjusted R-squared 0.0002 0.0006 0.0005 0.001 0.000 0.002 0.001 0.002 0.001 0.001 0.001 0.001
5. Conclusion
5.1 Discussion
The influence of dropping crude oil prices on a particular country is determined whether this country is a net importer or a net exporter of a natural resource and by strength of the national currency against USD. As it is proved empirically, dropped crude oil prices put burden on current account balances and foreign reserves for exporter countries. Currently all crude oil producers experience lower growth, nation-wide and market-wide stagnation but to a different extent. In this section I analyze the effect of oil price drop for each country separately.
Kuwait is extremely dependent on crude oil exports and has observed a significant
devaluation of dinar. The national currency of Kuwait decreased against the USD in the market reaching the levels in 2009-2009 and thus showing a lack of dinars as low crude oil prices strained the liquidity, which goes in line with the regression results presented in Table 5.1. From the other perspective, the depreciated currency indicates to paying more for imports that results in inflation. Crude oil generated revenue is 90% of Kuwaiti sovereign income and more than 50% of total GDP contributor. Current drop in oil prices causes Kuwait in enormous difficulties. Almost 90% of Kuwaiti citizens are employed in government sector, hence economic diversification is vital and by developing Kuwaiti private sector imbalances can be removed. Nearly all citizens are employed at the economic activities in the country are Hence, the economic diversification is quite crucial for the country that can be improved by developing a private sector in order to remove current account imbalances. Ability to prosper economically as well as financially can be achieved by developing other industries and sectors and trying to reduce crude oil dependence in the country.
Republic of Congo as many other African countries is abundant with natural resources
and recent price drop of oil affects the country’s budget as well as economic growth outlook. Oil is a dominant exporting commodity and recent drop certainly undermines not only the balance of payment but also fiscal positions of Congo. Decreased prices in oil have enforced the country to skip 478 million USD payments for its debt obligations (RT, 2016). As the grace period ended, the country officially defaulted on its bond payments, which was in foreign currency obligations. This resulted in downgraded rating from “B-“ into “SD/D” (Selective Default and “Default”) by Standard & Poor’s rating agency. If the Republic of Congo makes payments on its sovereign bonds, then the credit rating and access to international debt will be reviewed by the rating agency.The yield on bond has increased to
9,5% according to the data derived from Bloomberg (Welle, 2016). Currently the government has cut its spending that cause stagnation in GDP growth and higher inflation rates.
Nowadays Equatorial Guinea is encountering economic struggles due to drop in oil prices. The country is not receiving USD dominated revenues into its budget and currently export levels have shrinked by half (African News, 2016). At the same time production of crude oil has stagnated and most of Equatorial Guinean citizens have lots their jobs. The government has taken measures to diversify its economy and reduce oil dependence. According to Bloomberg, weak crude oil revenue flows requires reduction in public spending and investment (Bax, 2016)
Iraq as an oil producer is going through a recession and its national currency is getting
devaluated. Total reserves in USD have reduced by 20% and reached 59 billion USD according to July 2015 data (Cunningham, 2015).
Saudi Arabia is the leader in quota decisions within OPEC member states and an
important member in crude oil market. Troubles in Saudi Arabia are caused by the economic downturn in Asia, which accounts nearly 60% of Saudi Arabic oil sales. Currently national currency of Saudi Arabia is pegged to USD; however there is a hypothesis that decreased revenue may bring to nearly 1 peg fall (CNBC, 2016). Total reserves and current account budget are not strong enough for accommodating the continuous drop in crude oil revenues. Government officials of Saudi Arabia claim that the currency will not be let into free-floating rate and will be pegged to USD during the crisis. Financial authorities claim to sustain the peg as the floating rate will increase inflation and cause uncertainty with regards to financial stability.
Azerbaijan’s officials have discussed an emergency loan of 4 billion USD from the
World Bank and IMF with the main goal to boost business environment and stabilize the economy. The country shifted from fixed to floating currency exchange rates as of December 21, 2015 after more than 60% of total foreign reserves have been depleted. As it became challenging to defend the national currency the central bank shifted into a free-floating exchange rates. (Bloomberg, 2016)
Iranian riyal has devalued by 450% since the start of crude oil shocks. Oil exports
account for about 36% of Iran's total revenues and almost most of its of total export earnings. The country is facing a large budget deficit and lack of foreign reserves to defend its national currency. Export levels have significantly decreased and inflation has significantly risen. Iran was banned in participating in deals with world banks by the US, which causes difficulties in balancing the sovereign budget deficit (RT, 2016).
Venezuela has a USD dominated debt of 123 billion and is on the verge of default.
Although Venezuela is experiencing a crisis, the country managed to make 1.5 billion USD bond payments on time. Current credit rating of Venezuela is CCC according to Standard and Poor’s. Drop in oil prices lowers total foreign reserves significantly. Inflation levels in the country reaches 140% and the outlook by IMF estimates further economic downturn.
Kazakhstan faces difficulties regarding trading of crude oil with China and Russia and
goes though a very weak GDP growth as a result of a decrease in crude oil prices. Monetary authorities switched from fixed exchange rates to floating exchange rates, which increases market volatility and increases inflation levels.
Gabon’s budget was cut by more than 5% as a result of low oil prices and low revenues.
Two major oil companies dominate oil exploration in Gabon: Total and Royal Dutch Shell. Following the shocks in crude oil prices, authorities informed that it has taken steps to conduct reforms and diversify the economy (Reuters, 2016).
Oman has cut oil production that caused significant increase in unemployment levels for
its citizens. Moreover, as a highly oil dependent economy in times of crude oil shocks, the country has cut public spending with the goal to defend its national currency and keep the pegged rate of exchange. The country’s autocratic monarchy is corrupted and billions of foreign dominated currencies are drained from the national budget.
5.2. Cost of Production and Fiscal Break-even Prices
Crude oil production costs per barrel include capital spending, administrative and transportation costs, gross taxes per barrel. Usually production costs are higher in the US and Canada than in the Middle East and Africa. This can be explained by the fact that oil production in the US is based on North American shale including both horizontal drilling and hydraulic fracturing. For countries included in my sample cost of production per barrel is presented in Table 5.2.1.
Table 5.2.1: Cost of oil production per barrel
Country Cost of oil production per
barrel
Kuwait 8.5 USD
Republic of Congo 19.6 USD
Equitareal Guinea 17.3 USD
Iraq 10.7 USD
Saudi Arabia 9.9 USD
Azerbaijan 27.8 USD Iran 13.1 USD Venezuela 27.6 USD Kazakhstan 24.6 USD Libya 23.8 USD Gabon 15.6 USD Oman 10.5 USD
Currently, most of OPEC and non-OPEC members are below their fiscal breakeven prices. Breakeven price is a minimum prices per barrel needed to meet aggregate government expenditures. Fiscal break-even prices are expected to remain high for crude oil exporter nations. It is challenging to calculate long-term fiscal break-even prices as prices for crude oil fluctuate every day. Table 5.2.2 presents fiscal break-even prices per barrel of crude oil at which the governments would be able to “defend currencies” against depreciation. The data is based on 2015 values of crude oil.
As the table illustrates, fiscal break-even crude oil prices are high to maintain national budgets in balance. If crude oil value is lower than the required fiscal break-even, the country will face a negative current account balance, which may lead to depletion of foreign reserves in the long run.
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