Policies to Restore Orderly Oil Market ConditionsRemarks by John Lipsky, First Deputy Managing Director of the International Monetary Fund
At the Jeddah Energy Forum
Jeddah, Saudi Arabia, June 22, 2008
1. Minister Al-Naimi, my IMF colleagues and I would like to thank King Abdullah and the Saudi Arabian authorities for organizing this timely and important meeting. Restoring orderly oil market conditions has taken on new urgency in light of the likely destabilizing impact that the rapid and volatile movements in oil prices have on the global economy.
2. Let me begin by discussing the global macroeconomic implications of the recent oil price surge, which has surprised virtually all observers. To put this into context, current oil prices are now significantly higher in real terms than the previous record reached in the late 1970s.
• The oil price surge, together with the sharp rises in other commodity prices, has boosted inflation across the globe. In advanced economies, headline inflation has become uncomfortably high—at about 3½ percent in the euro area and 4 percent in the United States—at a time when economic activity is slowing notably. While measures of core inflation so far have remained quite well anchored, there are some signs that expectations are edging higher. This is complicating monetary policy decision making, as central banks have to tread a fine line between containing inflation and supporting demand, although slowing growth is likely to help eventually.
• The inflation concerns are even more serious in emerging economies. Inflation pressures have risen sharply, as the effects of the rising prices of oil and other commodities have come on top of pressures from strong growth in activity. The risks that the high oil and other commodity prices could spark more generalized inflation through second-round effects have risen in a number of countries, boosted also by the large weight commodity prices carry in consumer baskets while inflation expectations there are less firmly anchored. While many central banks have tightened their monetary policy stance, these responses often have been timid. As a result, real interest rates have turned negative in many countries, and inflation objectives look likely to be missed in many instances.
• Surging prices of oil and other commodities in tandem with higher inflation also present increasing downside risks to global growth, by reducing purchasing power, as well as from the increasing need for monetary policy tightening to contain inflation. If oil prices remain around current levels, they would, on average, be some $30 higher in 2008-09 than projected in late February. According to IMF estimates, such upward revisions imply lower annual global growth by about ½ to ¾ of a percentage point.
• The macroeconomic impact of rapid and unpredictable oil price movements extends well beyond inflation and growth. On the external side, the recent oil price surge is expected to lead to balance of payments difficulties in some fuel- and food-importing low-income countries in Africa and Central America that have not benefited from offsets from other commodity exports. We are working with these countries and stand ready to support them with our lending facilities. On the fiscal side, countries that have resisted full pass-through of international prices to end-users could experience significant deterioration in fiscal performance.3. What should be done? The answer to this question partly depends on the reasons behind the high oil prices. The background paper prepared for the conference clearly highlights that a complex set of factors has contributed to the high prices, and IMF analysis supports this diagnosis. Alternative analyses that attribute the price increases to one or two factors only are not convincing. For example, the emergence of oil and other commodities as an asset class or financial speculation have sometimes been singled out as key driving forces behind rising oil prices. However, while recognizing that financial factors have played a temporary role in the recent runup of oil prices—let me mention here the drops late last year in real policy interest rates and the U.S. dollar's earlier decline—it remains difficult so far to establish a lasting impact of financial commodity investment on oil price trends over the past few years. We will be cooperating with the IEA to study this issue further, as requested recently by the G-8 Finance Ministers in Osaka. It is important to recognize the essential role played by the underlying demand and supply fundamentals—the slow growth of new capacity and the continued strong demand in emerging economies—which have led to declining spare capacity and tight market conditions. 4.This brings me to the policy agenda. The background paper proposes a broad set of measures, which are broadly similar to our own policy recommendations. With such a broad agenda, however, a key question is that of priorities. Fundamentally, the first priority should be to loosen those policy constraints that have contributed importantly to the surge in prices. Specifically, priorities must squarely fall on policies that have fostered market rigidities and helped to prevent demand and supply from responding appropriately to the signals from rising prices. 5. On the demand side, the reduction in pass-through of international prices to domestic end-user prices over the past two years in a growing number of countries has reduced the price responsiveness of oil demand. This has amplified the oil price response to recent supply disruptions. Policy efforts therefore should aim to achieve prompt pass-through of international oil prices to domestic prices in the major consumer countries. 6. On the supply side, output projections routinely have been revised downward in recent years, particularly for non-OPEC producers. IMF analysis suggests that real oil investment has been held back by a confluence of cyclical, technological, geological, and policy constraints. Among the latter, the deterioration in the investment climate and the oil investment regime in a number of countries, as well as limits on the cooperation of national oil companies with international oil companies stand out. The perception that a meaningful supply response to high prices may be slow in coming has been one reason for increasing market pessimism and a steady increase in long-dated futures prices. Improving the stability and predictability of investment regimes and encouraging greater cooperation between national and international oil companies would strengthen the supply response. 7. More timely and adequate data concerning global supply and demand conditions will enable investors to better anticipate future trends in production and make oil markets more predictable and transparent. 8. Such policies would be key to foster improved supply-demand balances, as they will allow oil prices to truly reflect the scarcity of the resource. Policy action along these lines is most likely to be successful if it is undertaken in a multilateral context where everyone does their share—and is perceived as doing so—to improve the supply-demand balance in oil markets. 9. Let me conclude by emphasizing the urgency of policy actions, not just for oil market stability, but also for stability in the global economy. A strong set of policy actions along the lines being suggested would send important signals to oil markets. While many policies would not immediately lead to changes in oil demand and supply, they nevertheless can help to anchor expectations and reverse market sentiment, and have an effect on current prices. This is important because the sharp widening of the range of possible future oil prices implied in prices of oil futures options suggests that markets are increasingly uncertain about where oil markets are heading. In the circumstances, minor events or developments can potentially have large price effects, to the detriment of global economic stability.