Crude Oil Price Volatility Economics Essay

Energy plays the central role in the world economy. In spite of considerable inclination to alternative renewable sources of energy like wind, water, nuclear and solar power, the role of crude oil in macroeconomic movements has not waned yet (Mehrara & Mohaghegh, 2011).

Since the discovery and production of oil Nigeria in 1958, the subsector has continued to play a major and dominant role in the Nigerian economy. The extractive sector in the Nigerian economy is large and extensive, with oil playing a vital role. With nearly 37.2 billion barrels in reserves and 2.13% of global production, Nigeria has the world’s tenth largest proven reserves (3.1% of global reserves), and is among the top 10 oil producers (Akinlo, 2012).

Nigeria has been a member of the Organization of the Petroleum Exporting Countries (OPEC) since July 1971. Currently, there are 12 member countries including Nigeria in this international organization whose aim of the organization, according to its Statute, is the determination of the best means for safeguarding their interests, individually and collectively; devising ways and means of ensuring the stabilization of prices in international oil markets with a view to eliminating harmful and unnecessary fluctuations; giving due regard at all times to the interests of the producing nations and to the necessity of securing a steady income to the producing countries; an efficient, economic and regular supply of petroleum to consuming nations, and a fair return on their capital to those investing in the petroleum industry (OPEC, 2012).

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Crude Oil is an important commodity not just because it is naturally occurring in the earth but because of the many fractions that are derived from it after the refining process. Those varying fractions such as fuel oil, jet fuel, kerosene etc. are extracted at different temperatures during the refining process.

The demand for crude oil is derived from the demand for its fractions and it depends on a large number of factors such as its grade, sulphur content and its locations. Crude Oil is classified in the international market according to varying molecular characteristics by giving pricing references to the areas where such barrels are produced. Such pricing references include the North American West Texas Intermediate, Nigerian Bonny Light, Brent etc.

In most oil exporting countries, government which is considerably large in comparison with small private sector, directly receives the oil revenue. Spending this revenue, government’s behavior becomes the most important characteristic of the economy. In other words, the funds needed for government’s expenditure come from oil revenue. So, fiscal and monetary policies depend upon oil price (Rosser & Sheehan, 1995).

Oil price is highly variable; even more than any other commodity (Dehn, 2001). Crude oil prices have increased on average from US $25 per barrel in 2002 to US $55 per barrel in 2005. There has been a steep upward trend in the price of crude oil in recent years, reaching a record nominal high of US $147 in mid-2008 and a sharp drop to US $46 a barrel (Akpan, 2009).

The transmission mechanisms through which oil prices have impact on real economic activity include both supply and demand channels. The supply side effects are related to the fact that crude oil is a basic input to production, and consequently an increase in oil price leads to a rise in production costs that induces firms to lower output. Oil price changes also entail demand-side effects on consumption and investment. Consumption is affected indirectly through its positive relation with disposable income. Oil price rises reduce the consumers spending power. Investment may also be affected if the oil price shock encourages producers to substitute less energy intensive capital for more energy-intensive capital. The magnitude of this effect is in turn stronger the more the shock is perceived to be long-lasting. For this reason, the theoretical literature has been of a general equilibrium nature, with different authors assigning different weights to the supply and demand channels (Olomola & Adejumo, 2006).

When oil price depreciates, large public sector expectedly cannot reduce its spending immediately and proportionately; then faces huge deficits. The fiscal imbalances followed by an oil price decrease can be devastating if the country is highly dependent on oil revenues; which is the case in most oil exporting countries. More disappointingly such falls are usually unpredictable. Several incomplete projects and huge debts are the main inheritances of this period for the following fruitful era. After some harsh experiences, nowadays, isolating the real sectors of economy from oil price volatility is accepted as one of the most important roles of government (Mehrara & Mohaghegh, 2011).

Currently, annual budgets are formulated in Nigeria based on oil prices. The 2009 budget was revised in line with the prevailing market price of oil indicative of huge dependence of Nigeria on oil proceeds. In 2012, there was an intense debate concerning the benchmark price of Crude Oil that would be the basis of revenue and expenditure calculations in the passing of the 2013 Appropriation Act (budget) through the Nigerian National Assembly.

Huge inflow of oil revenues in Nigeria are more often associated with expansion in the level of Government spending while periods of dwindling oil revenues are usually accompanied by budget deficits. There is no gain saying that Nigeria relies so much on revenue from oil exports, but, it equally massively imports refined petroleum and other related products. Evidence, for instance, shows that Government spending, which hitherto, before 1999 remained well below N0.5 trillion, hit N1.02 trillion mark in 2001 and N1.5 trillion in 2004. The figures for 2006 and 2007 stood at N2.04 and N2.45 trillion respectively (Aliyu, 2009).

Oil price shocks are predominantly defined with respect to price fluctuations resulting from changes in either the demand or supply side of the international oil market (Hamilton, 1983). These changes have been traditionally traced to supply side disruptions such as OPEC supply quotas, political upheavals in the oil-rich Middle East and activities of militant groups in the Niger Delta region of Nigeria. The shocks could be positive (a rise) or negative (a fall). Two issues are identified regarding the shocks; first is the magnitude of the price increase which can be quantified in absolute terms or as percentage changes, second is the timing of the shock, that is, the speed and persistence of the price increase (Akpan, 2009).

Going by the foregoing, four oil shocks can be observed in Nigeria. Each of the shocks had connections with some movements in key macroeconomic variables in Nigeria. For instance, the 1973-74, 1979-80, and 2003-2006 periods were associated with price increases while the oil market collapse of 1986 is an episode of price decrease. During the first oil shock in Nigeria (1973-74), the value of Nigeria’s export measured in US dollars rose by about 600 per cent with the terms of trade rising from 18.9 in 1974 to 65.3 by 1982. Government revenue which stood at 8 per cent of GDP in 1972 rose to about 20 per cent in 1975. This resulted in increased government expenditure owing largely from the need to monetize the crude oil receipts. Investment was largely in favour of education, public health, transport, and import substituting industries (Nnnanna & Masha, 2003).

During the oil price shock of 2003-2006, Nigeria recorded increase in the share of oil in GDP from about 80 per cent in 2003 to 82.6 per cent in 2005. The shock was gradual and persisted for a while. This could be regarded as a permanent shock. The result of the shock was a favourable investment climate, increased national income within the period although a slight decline was observed in the growth rate of the GDP. Despite this perceived benefit of oil price change, the macroeconomic environment in Nigeria during the booms was undesirable. For instance, inflation was mostly double digit in the 1970s; money supply grew steeply, while huge fiscal deficits were also recorded (Akpan, 2009).

The growth path of the country has been very rough over the years. During the oil boom era, roughly 1970-78, GDP grew positively by 6.2 percent annually – a remarkable growth. However, in the 1980s, GDP had negative growth rates. In the period 1988-1997 which constitutes the period of Structural Adjustment Programme (SAP), which entails economic liberalization, the GDP responded to economic adjustment policies and grew at a positive rate of 4.0 percent. Agriculture, industry and manufacturing, oil and gas sectors had greater dominance in the composition of the Nigeria’s GDP. The year 1989 – 1998 was the most turbulent period in the history of the country’s growth pattern. Real GDP grew only by an average of 3.6 percent, against the population growth rate of 2.8% during the same period. Inflation, poverty, exchange rate were all at alarming rates. Foreign direct investment, which is a necessary engine of growth, was stifled because of unsupportive enabling environment. Between 1999 and 2008, the country’s growth performance improved significantly. GDP growth rate averaged 7.8% during the decade solely due to the growth of non-oil sector which grew by 9.5 percent. In this regard, however, oil sector constitutes both a drag on growth and a source of instability in GDP growth pattern (Aliyu, 2009).

Ongoing fiscal and monetary reforms aim to reduce the level of crude oil dependency but at the moment, uncertainties about the level of crude oil prices has cost the economy a lot of investment opportunities over the years. In order for Nigeria to attain balanced, continuous and sustainable economic growth, the effect of volatility in oil prices must be given adequate attention.

STATEMENT OF THE PROBLEM

In Nigeria, the rate of crude oil dependency is high. It accounted for about 82.1% of total government revenue during the oil boom in 1974 before reducing to a share of 64.3% by which was a consequence of the rapid decline in world market price of crude oil. The share of oil revenue in total government revenue still remains substantial as evidenced by the attainment of 85.6% and 86.1% in 2004 and 2005 respectively (Akpan,2009). This has generated a lot of interest especially amongst stakeholders in the Nigerian economy. Of recent, is the debate in the Nigerian National Assembly about the appropriate crude oil price benchmark to be included in the 2013 Appropriation Act which has generated a lot of controversy.

From a planning perspective, fluctuations in the crude oil price have been the source of a lot of uncompleted government projects due to the changes in the revenue stream and the reliability of cost estimates. The transmission mechanisms through which crude oil prices impact on real economic activity and analyzing the dynamic interrelationship among the selected macroeconomic variables is of great importance.

Variations in crude oil prices hinders effective economic planning and development most especially for crude oil dependent economies like Nigeria. The impact of these fluctuations in terms of magnitude, duration and direction is of great importance if the Nigerian economy must progress.

The following are questions pertaining to the impact of crude oil price volatility in Nigeria:-

How significantly can Crude Oil Price fluctuations hinder sustainable economic growth in Nigeria?

What magnitude of the changes in macroeconomic variables is associated with fluctuations in crude oil price?

1.3 OBJECTIVES OF THE STUDY

The broad objective of this study is to analyze the effect of crude oil price volatility on economic activity in Nigeria. The specific objectives include:

a. To analyze the effect of oil price volatility on the growth rate of real GDP, Inflation rate, Money supply and other fiscal and monetary variables.

b. To determine whether there is a long run relationship between oil price volatility and real GDP growth in Nigeria.

1.4 RESEARCH QUESTIONS

The questions that guide the research are as follows:

a. Is there a significant relationship between Oil price shocks and economy activity in Nigeria?

b. What is the magnitude of the relationship (if any) between Oil price shocks and macroeconomic variables in Nigeria?

1.5 HYPOTHESES OF STUDY

The following are the research hypotheses to be tested during the study:

Ho: Crude Oil Price has no significant effect on economic activity in Nigeria.

H1: Crude Oil Price has a significant effect on economic activity in Nigeria.

1.6 SCOPE AND LIMITATIONS OF THE STUDY

This study on the effect of volatile economic activity may be relevant to all countries in the world but the overall considerations, analysis and implications are within the framework of the Nigerian economy. This study covers the periods from 1975 to 2011. However, limitations due to unavailability and unreliability of data could arise in the course of the study and this should not be overlooked.

1.7 DEFINITION OF UNFAMILIAR TERMS

The following terms used during the study are explained below:

a. Volatile: Tending to vary often or widely

b. Organization of Petroleum-Exporting Countries (OPEC): An organization of countries formed in 1961 to agree on a common policy for the production and sale of petroleum. Its members include Iraq, Indonesia, Iran, Kuwait, Libya, Angola, Algeria, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela.

1.8 SIGNIFICANCE OF STUDY

This study is important to show the extent to which the Nigerian economy is affected by crude oil by examining macroeconomic variables. It is necessary to understand the direction, duration and magnitude of the relationship.

1.9 METHODOLOGY

The variables to be considered include:

a. Oil Price Variance

b. Real Gross Domestic Product Growth Rate

c. Inflation Rate

d. Index of Industrial Production

e. Money Supply

f. Government Expenditure

The time period under consideration is 1975-2011. The Ordinary Least Square Method is used because it is the best linear unbiased estimator. Garch (1,1) model is used to measure crude oil price volatility and the conditional variance series generates the volatility data. Johansen Co-Integration technique based on vector autoregressive model determines the long run relationship between oil price fluctuations and GDP growth. Vector Error Correction Model (VECM) specifies convergence or divergence among the variables in the model. Tests for Stationarity (existence of unit roots) such as the augmented dickey-fuller and Phillip Perron Tests will be employed. Variance decomposition, impulse response function, granger causality test examines effect of Oil Price volatility on other variables.

1.10 DATA SOURCES

Secondary data sources from Central Bank Statistical Database, Central Bank Statistical Bulletin, OPEC Statistical Bulletin British Petroleum Statistical Review of World Energy.

1.11 OUTLINE OF CHAPTERS