IMF WEO 2011: Oil Scarcity, Growth, and Global Imbalances

The latest International Monetary Fund (IMF) World Economic Outlook (WEO) published last month (April 2011) makes for very interesting reading, Chapter 3 specifically: “Oil Scarcity, Growth, and Global Imbalances”.

Considering the findings of the report, it’s remarkable the relatively little press the report has received, and I can find none in the Irish media. All the more remarkable considering their role in our bail-out.

Chapter 3 considers four future oil production scenarios, one of which being a ‘Peak Oil’ scenario (Scenario 2):

• Benchmark scenario
  • world oil production increases by only 0.8% versus business as usual (BAU) 1.8%
• Scenario 1: Greater substitution away from oil
  • assumes a more optimistic long-term elasticity of 0.3, almost five times as high as that used in the benchmark scenario
• Scenario 2: greater declines in oil production
  • -2% per annum (-3.8% vs. BAU)
  • 4% real increase in extraction costs per year (vs 2% in benchmark scenario)
• Scenario 3: greater economic role for oil
  • the contribution of oil to output (either directly or as an enabler of technology) amounts to 25 percent in the tradables sector and 20 percent in the nontradables sector (rather than 5 percent and 2 percent).

Oil production assumptions in the IMF model

The chart above demonstrates the oil production scenarios used in the model.

For this study, the researchers took the IMF’s ‘standard’ economic model, GIMF (Global Integrated Monetary and Fiscal Model), which is a a multiregion dynamic general equilibrium model, and made some rather ground-breaking modifications – at least if you’re a neoclassical economist.

The main difference between this application and the standard version of the GIMF is that oil is a third factor in an economy’s production, in addition to capital and labor, and a second factor in final consumption, in addition to goods and services. The price and availability of oil therefore influence production as well as consumption possibilities.

This is a very substantial break from the conventional Solow-Swan model (for which Solow won the Nobel Prize in 1987). This thinking reflects that described by Ayres & Warr (referenced in this IMF report) in their recently published book ‘The Economic Growth Engine‘ (2009). They develop a metabolic model of industry based on exergy and efficiency as the primary determinants of economic growth in industrial society. This allows them to drop the critical assumption of ‘technological progress’, while still explaining GDP growth. Ayres & Warr critically deconstruct neoclassical economics and highlight, yet again, its shortcomings as a model to explain and forecast economic performance. As such they represent yet another paradigm shift away from the old school. That the IMF would see fit to adopt it for this report demonstrates how the paradigm of the old school is starting to be replaced.

The authors then model oil demand using a function based on consumption elasticities. Long- and short-term elasticities are determined  using a regression model of per capita oil consumption and real per capita GDP. The results bear out the belief in the special nature of oil:

• very low short-term price elasticity, about –0.02. This implies that a 10% increase in oil prices leads to a reduction in oil demand of only 0.2%
• long-term price elasticity is 4 times larger, implying a 10% permanent increase in oil prices reduces oil demand by about 0.7% after 20 years.
• short-term income elasticity is about 0.68, implying that a 1% increase in income is associated with an increase in oil demand of 0.68%

The authors’ paradigm shift is only partial, they’re still principally using a general equilibrium model. Yet, even in this regard, they explicitly acknowledge the limitations of their model:

In each of the GIMF scenarios, the transition to a new equilibrium is, by assumption, a smooth process:
– consumers in oil-exporting economies easily absorb large surpluses in goods exports from oil importers,
– financial markets efficiently absorb and intermediate a flood of savings from oil exporters,
– businesses respond flexibly to higher oil prices by reallocating resources, and
– workers readily accept lower real wages.
Some of these assumptions, however, may be too optimistic.

Indeed.

The results of the simulation are summarised below:

The report observes, that based on its simulations, the benchmark scenario is relatively benign. Scenario 1, an admittedly optimistic scenario, given the assumption made, of a gradual move to a reduced dependence on oil, is moderately better. From there on the scenario results become rather unsettling. Scenario 2 (the ASPO scenario), results in an immediate tripling of oil prices, going to 800% increase at the end of the simulation period, 20 years hence. Of more interest to our politicians (and paymasters) is the impact on economic growth and Europe’s current account. The results from scenario 3 (pseudo Ayres-Warr) are less dramatic, being somewhere between the worst case scenario (ASPO) and the benckmark scenario.

However, the study fails to consider the very obvious possibility of a combination of Scenarios 2 and 3, i.e. both ASPO and Ayres-Warr being correct. If the Ayres-Warr scenario doubled the impact of the benchmark scenario, then we might reasonably assume that it will do the same to the ASPO scenario, making the worst-case twice as bad.

The report summarises the scenarios, pointing out:

But if the reductions in oil output were in line with the more
pessimistic studies of peak oil proponents or if the contribution of oil to output proved much larger than its cost share, the eff ects could be dramatic, suggesting a need for urgent policy action.

From the references, the authors studied the Hirsch Report (2005) and the work of the UK ERC’s Global Oil Depletion Report (2009). Undoubtedly the most significant finding from the ERC report is:

A peak in conventional oil production before 2030 appears likely and there is a significant risk of a peak before 2020. Given the lead times required to both develop substitute fuels and improve energy efficiency, this risk needs to be given serious consideration

What does the IMF consider are the policy implications?

Fundamentally, there are two broad areas for action:
First, given the potential for unexpected increases in the scarcity of
oil and other resources, policymakers should review whether current policy frameworks facilitate adjustment to unexpected changes in oil scarcity.
Second, consideration should be given to policies aimed at lowering the risk of oil scarcity, including through the development of sustainable alternative sources of energy.

Given the impact of the banking crisis on Ireland’s economy, probably the most salutary warning in the report, in light of what’s gone above, is regarding the threat Peak Oil poses to our already fragile banking system:

The adverse effects of large-scale bankruptcies in such industries [car manufacturing, airlines, trucking, long-distance trade, and
tourism] could spread to the rest of the economy, either through corporate balance sheets (intercompany credit, interdependence of industries such as construction and tourism) or through bank balance sheets (lack of credit after loan losses)

The challenge we face, from a policy perspective, is getting the mix of short-term and long term policies right such that we can get through the near-term disruptive risks on the long road to decarbonising our society.

The area of appropriate policy responses will be explored in a future post.

Contents:

Tensions from the Two-Speed Recovery: Unemployment, Commodities, and Capital Flows

Chapter 3. Oil Scarcity, Growth, and Global Imbalances
1.What Are the Main Findings?
2.Has Oil Become a Scarce Resource?What is oil scarcity?

• • • How do we measure scarcity?
    • What lies behind the apparent increase in oil scarcity?
      • What are the prospects for overall energy consumption?
      • What are the prospects for oil demand?
      • What are the prospects for oil supply?
    • What are the implications for oil scarcity?

3.Oil Scarcity and the Global Economy

• • • What is the model and how is it calibrated?
    • How will lower oil supply trends affect the global economy?
    • Alternative scenarios?
      • Scenario 1: greater substitution away from oil
      • Scenario 2: greater declines in oil production
      • Scenario 3: greater economic role for oil
      • Summary of the simulations
    • Additional considerations

4.Implications for the Outlook and Policies

Appendix 3.1. Low-Frequency Filtering for Extracting Business Cycle Trends
Appendix 3.2. The Energy and Oil Empirical Models
References

ASPO-Ireland