Policy interventions for Guyana’s dependency on crude oil and financial implications

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Bobby Gossai, Jr.
Bobby Gossai, Jr. is currently pursuing the Degree of Doctor of Philosophy in Economics at the University of Aberdeen with a research focus on Fiscal Policies and Regulations for an Emerging Petroleum Producing Country. He completed his MSc (Econ) in Petroleum, Energy Economics and Finance from the same institution, and also holds an MSC in Economics from the University of the West Indies. Mr. Gossai, Jr.’s professional experiences include being the head of the Guyana Oil and Gas Association and senior policy analyst and advisor at the Ministry of Natural Resources and Environment.

In the context of the oil price volatility (OVP), which is occurring, the global dependency on crude oil has serious financial implications; chiefly, trade deficits are now foremost the result of expenditure allocated to crude oil imports. Expenditure devoted to crude oil imports as a percentage of the trade balance will significantly decrease in many countries, given that there is a declining consumption following the effects of the global pandemic.

The potential adverse pressure on trade balances will change in oil-importing countries over the coming months as the price of oil continues to regain some level of stability. This does not imply that pressure on Guyana’s trade balance, as a result of increasing oil prices, should no longer likely to be a problem. Pressure on the disposable incomes and consumption patterns of Guyanese consumers would still remain high as domestic Guyanese oil prices are, after all, dictated by global market forces. Thus, the possibility of future energy self-sufficiency does not eliminate the macroeconomic problems created by the increasing trend in oil prices; it merely alters the specific framing of the problem (Bolgar 2013).

In contrast, Guyana will have to successfully maintain a trade surplus for the next decade that must be stimulated by the vitality of its export sector and its expenditure on imported crude oil as a percentage of the trade surplus. Even though the expenditure devoted to imported crude oil as a percentage of the Guyanese trade surplus may be stagnated in the coming decade, Guyana will still be spending a substantial proportion of its trade surplus to finance domestic oil consumption. The acute import dependency can be hazardous in the event of a negative economic shock.

Price volatility is primarily driven by supply-side factors but mainly has demand-side impacts. Policy to reduce price volatility and its associated adverse macroeconomic effects must, therefore, encompass both supply-side and demand-side solutions. The primary focus of supply-side (preventative) policy should be the stabilisation of oil supply because the largest increases in price volatility have historically arisen from supply-side oil disruptions. To an extent, the market is self-correcting in this regard.

Production practices from the largest oil producers in order to stabilise prices, such as the increased production levels in Saudi Arabia to offset geopolitical tensions, suggesting that oil producers are concerned about the adverse long-term demand-side impacts of sustained low oil price intervals and are unwilling to tolerate both low prices and volatility in the market.

Global cooperation and concerted action will thus be fundamental in the management and reduction of future price volatility. In this regard, the International Energy Agency (IEA) collective action framework, which mandates the maintenance of strategic oil reserves, has recently been highly effective on several occasions in reducing the extent of price volatility in the context of oil-supply disruptions.

Strengthening and expanding IEA and analogous systems will thus be important in enhancing future market stability. One possibility might be the legislative requirement that companies and industries which are heavily reliant on oil-powered production processes, should maintain individual strategic oil reserves to provide effective insulation from price volatility.

Supply-side risk management policies are important but at best can only minimise OPV and its associated macroeconomic effects. Macroeconomic isolation from OPV can only be achieved through a combination of supply and demand-side policies. Demand-side policy should prioritise strategies that reduce oil dependency, such as disincentivising oil consumption through tax and subsidy reform, improving sectoral energy efficiency and facilitating greater diversification in the global energy mix.

Institutionalised oil price subsidies in emerging and developing countries have augmented the global structural dependence on oil and provided little incentive for lowering oil consumption (Saporta 2009). An important initial policy step would be the review of national energy subsidy policies to assess the areas in which there is the greatest scope for both subsidy and tax reform in relation to oil consumption. Due to the fundamental dependence of mobility on crude oil-derived fuels, energy subsidy and tax reforms and improvements in energy efficiency must be all centred around innovations in the transportation sector. Fuel taxes have raised consumer awareness about the fuel economy of vehicles and have been particularly effective in improving fuel economy and reducing vehicle emissions in many developed countries. However, several strategies to improve energy efficiency in the transportation sector including the adoption of fuel-economy standards and the construction of codes and requirements for greater efficiency in power plants, have been restricted by poor government organization (IEA 2012). Significant political will is thus required to achieve effective policy reform related to energy efficiency standards. Governments must also play a role in creating a facilitating environment in which a diversified set of alternative and renewable sources of energy can thrive.

Part of this role includes the re-alignment of the financial industry in order to increase its contribution toward the funding of alternative energy sources. Alternative fuels that have the potential to be used in the transportation sector, including algae-derived fuels, natural gas, hydrogen, and decarbonised electricity, all require significant financial backing before they can become economically viable.

Finally, the significant growth and impact of speculation on price volatility over the past decade have highlighted the necessity of policies that constrain the misuse of the oil derivatives market. To effectively gauge and address speculative activity, policies to improve the systems of identification of traders and their respective positions are necessary so that regulators are better able to manage speculative activity. This may necessitate the adoption of an American style model in the Guyanese trading exchanges. The mandatory classification of traders and their respective positions could, for example, be exported to the Intercontinental Exchange (ICE). Additionally, improvements in the general quality and transparency of both physical and financial oil market information would lessen market uncertainty and price volatility by improving the accuracy and homogeneity of price expectations. Strengthening and expanding the scope of oil market information and assessment systems by instituting policies to improve consistency and reliability in data submissions is thus essential in lessening future price volatility.

The high degree of OPV that has characterized the market for the past four decades represents a fundamental barrier to economic growth, due to its damaging and destabilizing effects on the macroeconomy. Through the generation of economic uncertainty, OPV adversely impacts aggregate consumption, investment, and industrial production, resulting in an indirect ripple-through impact on aggregate unemployment and inflation. Uncertainties pertaining to future income streams under OPV decrease consumer demand while increasing the randomness of consumption. This prompts the decrease of physical investment expenditure in both the short and medium-term. However, as the pool of savings available for investment expands, greater aggregate investment is facilitated in the long term. Short-term financial investment, in contrast, may increase in response to OPV (depending on the degree of risk preference which characterizes the financial market at any given time) reflecting risk premium revision and perceived opportunities for financial gain as price deviations increase. Industrial production is also adversely affected under OPV, due to the impact of price volatility on consumer demand and production costs. However, because production cost uncertainty can be offset through price increases, OPV only guarantees declining industrial production in the short run if its effect on consumption is greater than its impact on production costs.

The effects of OPV on consumer, investor, and producer behaviour, strongly influence both the level of inflation and the level of unemployment within economies affected by OPV. Under OPV, the term-structure of inflation is likely to correspond to a U-shape, in reflection of the relative weights of the inflationary and deflationary pressures created by OPV over time. In response to the decline in industrial production, investment and consumption, unemployment also significantly increases under OPV. However, the precise extent to which unemployment is affected by price volatility will depend on the contribution of the industrial sector to the Gross Domestic Product (GDP) and the structure of labour market laws. The finding that OPV both increases unemployment and inflation and decreases economic growth suggests that OPV pushes the economy into a stagflationary mode (Zoheir et al. 2014).

A combination of supply-side and demand-side policies aimed at preventing and providing a solution to OPV is vital if stability in future economic growth trajectories is to be achieved. An expansion of systems that mandate global cooperation and concerted action in oil supply chain management, such as the IEA collective action framework, is necessary in order to minimise short-term price volatility and promote market stability. In addition to supply-side disruptions, high-frequency trading (speculation) is also a significant driver of short-term OPV. Policy must focus on realigning the use of the oil derivatives market away from speculation and toward its initial purpose: hedging. Improving derivatives market regulatory systems and working toward international derivatives regulatory standards will be vital in achieving this goal but efforts to curb speculation so far have been lacklustre.

In the medium and long-term, the main task of governments should be to create a facilitating environment which incentivises infrastructural investments and the production of a diversified set of alternative renewable fuels that can be used as a substitute for oil, particularly in the transportation sector. Complementary to this is demand-side management policies to reduce the global structural dependence on oil. Part of this role will require the politically challenging task of energy subsidy and tax reform to incentivise the consumption of alternative fuels and disincentivise oil consumption, particularly in emerging economies such as Guyana, where oil price subsidies could be institutionalised. Nevertheless, a significant opportunity in reducing the demand for oil is also to be found in policies that are aimed at improving energy efficiencies such as the adoption of fuel-economy standards and the construction of codes and requirements for greater energy efficiency in various sectors of the economy.

It must be emphasised that the significant production capacities of unconventional fossil fuel reserves coming online over the next decade are highly likely to mitigate price volatility and keep prices – least relatively – low. While this is terrible news for the environment, it is excellent news for the economy: unconventional reserves could provide the dearly needed economic boost and they will “buy us time” for decarbonisation endeavours. On the long run, these decarbonisation endeavours will be essential in order to increase sustainability, mitigate climate change and decrease dependence on fossil feedstock.

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