The IMF’s latest report on the global crude oil outlook can be considered as frightening. Titled as “The Future of Oil: Geology versus Technology,” the International Monetary Fund tried to find a way around the geological case, which discusses that the world has hit critical scarcity on recoverable oil deposits.
Oil demand shocks have been significantly larger in size, and have been a major contributor to high oil prices especially in the period prior to the Great Recession, and in the recent partial recovery from that recession. Oil demand shocks have also had much more persistent effects on oil production and GDP (Gross Domestic Product) than oil supply shocks. Their effect on the real price of oil has not been as sharp, but again more persistent.
Estimated output gap shocks have very large and persistent effects on GDP that lead to similarly large and persistent effects on oil demand. Of course the dominant output gap shock during the crisis has been a negative shock that reduced economic activity and oil demand. The resulting large effect on the oil price is a major part of the model’s explanation for the steep drop in oil prices following the onset of the Great Recession.
Oil supply, at least until some time in 2005, actually helped to, ceteris paribus, keep oil prices lower than what they would otherwise have been. From that time onward however, as we have seen, world oil production stayed on a plateau, and by 2008 insufficient world oil supply had become the major factor behind high oil prices. The Great Recession, from 2009, was so severe that oil prices dropped below the original 2002 forecast.
There is likely to be a critical range of oil prices where the GDP effects of any further increases become much larger than at lower levels, if only because they start to threaten the viability of entire industries such as airlines and long-distance tourism.
Oil price doubles by 2021!
Average oil output growth drops from 0.9% to 0.5% per annum, the oil price now fully doubles by 2021, and the path for GDP is approximately equal to the lower 90% confidence band. This last result implies that this one change alone reduces the point forecast for average world output growth by approximately 1 percentage point.
As for the contribution of oil to GDP, the main problem is that conventional production functions imply an equality of cost shares and output contributions of oil, which for a long time has led economists to conclude that, given its historically low cost share of around 3.5% for the U.S. economy, oil can never account for a massive output contraction, even with low elasticity of substitution between oil and other factors of production. This view has been challenged in several recent articles and books by natural scientists, which state that it need not hold with a more appropriate modeling of the aggregate technology.
The other key concern going forward concerns elasticity of substitution. Several important contributions challenge economists’ automatic assumption that elasticity of substitution between oil and other factors of production must be much higher in the long run than in the short run.
For the U.S. economy the historical cost share of total energy has been around 7%.
Sufficiently large shock to the growth rate of world oil supply, because there is a finite limit to the extent that machines (and labor) can substitute for energy. If this assumption were incorporated, the model would forecast significantly higher oil prices in the event of a sufficiently large and persistent shock to world oil supply.
* Reference: IMF’s Working Paper on “The Future of Oil: Geology versus Technology”