Barrel Bill, 2012

Barrel Bill: The Update

We define the barrel bill as the value of aggregate oil imports by net oil importing economies as a share of these countries' combined GDP (for more details, see Box 3 below). At around US$2.3 trillion, the (first stage) wealth transfer from oil importers to oil exporters in 2011 reached all-time highs in dollar terms. As a share of aggregate oil importers' GDP, the barrel bill has surpassed the 2008 level of 3.2%. Put differently, over 2010 and 2011, the barrel bill has more than fully recovered the 1.2% of oil importers' GDP drop that it suffered between 2008 and 2009. In terms of aggregate oil exporters' GDP, the value of global oil trade last year was around 23.3% - compared to the all-time high of 23.7% in 2008.

To put these levels into historical perspective, they are still meaningfully lower than in the early 1980s, when the oil wealth transfer was 5.9% (34.3%) of oil importers' (oil exporters') combined GDP for 1980 and 4.2% (28.4%) for 1981. As we will see below, however, realistic scenarios for the oil price could bring the barrel bill to 1981 levels this year. What happens to this oil revenue? It gets ‘recycled' into goods and assets (see Box 1 below for more details).

Oil revenue recycling 1: Goods: Of the US$2.3 trillion barrel bill, around 50% will, over time, return to oil-importing economies in the form of export revenue: oil exporters spend around half their oil revenue on goods imports from oil importers (the ‘average propensity to import out of oil revenue'). Indeed, we think it is likely that this share will increase as oil exporters bid to maintain social stability (that is, the marginal propensity to import out of oil revenue may soon rise). In any case, the net wealth transfer - i.e., after accounting for this (second stage) wealth transfer back to oil importers - is thus much smaller than the gross (first stage) transfer.

Oil revenue recycling 2: Assets: This leaves around US$1.1 trillion unspent. While some of this will no doubt be spent on domestic goods and services (or on goods and services from other oil-producing economies), it is fair to assume that the lion's share will be saved, that is, invested - mainly in assets from the oil-importing economies. If this flow of saving is US$1 trillion, it would be equivalent to 1.8% of global equity market capitalisation.

What Does it Mean for Growth?

Unfortunately, there is no consensus in economics regarding the consequences of oil shocks for real GDP. We sidestep this problem by using the barrel bill concept to look at the potential implications of the current oil price surge for global growth.

As we explain in Box 2, we prefer to look at the change in the barrel bill rather than the level. Further, the underlying drivers of the barrel bill matter, i.e., shocks to oil demand or supply, whether the shock is permanent or transitory, and of course whether it is large or small.

Beginning from this reasoning, we note:

• The current oil price surge is not (yet) very persistent: in real, domestic currency terms, the six-month trailing average of the price of oil for some economies - namely the US, China, Japan and the UK - has not yet reclaimed last year's highs.

• In fact, in the US the share of energy in total household expenditure has actually declined lately, courtesy of a mild winter (which reduced the volume of demand) and lower gas price quotes (which reduced the price of energy for some households).

Further, the barrel bill concept can help us to gauge the impact of oil on the global economy.

Scenario analysis: Using assumptions about oil prices for the rest of the year and the responsiveness of demand to prices (‘price elasticity of demand'), we can construct different scenarios for the 2012 barrel bill - and its change over the 2011 barrel bill.

At current oil prices (around US$125 for Brent), our scenarios indicate an increase in the barrel bill of about 0.2-0.4pp of oil importers' combined GDP compared to last year. This is roughly in line with the average increase in the barrel bill over the last ten years (0.3% of GDP). That, in general, has not been recessionary in the past. In addition, we take heart from the fact that despite a sizeable increase in the barrel bill between 2010 and 2011 (of 0.9% of GDP), 2011 was not a recession year for the global economy (although it did weaken the US economy in the first half). This despite: i) general DM sluggishness induced by deleveraging; ii) the global shock from the Japanese catastrophe; and iii) the European sovereign and banking crisis.

An oil price at US$150 per barrel would, depending on the demand responsiveness, add at least 0.7% of GDP to the barrel bill of oil importers. It is likely - although not certain - that this would tip some of the more fragile parts of the global economy into recession, particularly in DM. It would also bring the share of GDP importers' spend on oil to well above 4%, levels we haven't seen since the early 1980s (the barrel bill declined from 5.9% of oil importers' GDP in 1980 to 3.5% in 1982). In short:

• Oil prices at current levels are a drag, but should not be too much of a problem for oil importers and the global economy as a whole.

• A meaningful further rise in oil prices from current levels, say to US$150, could tip the more fragile parts of the global economy into recession, particularly in DM.

A final worry: It is always worth bearing in mind that it is difficult to draw conclusions about the future path of the economy from correlations; ‘all else' is rarely ‘equal'. One of the ways in which this oil price surge could impact the economy is indirect: by rendering global monetary policy less accommodative. This may already be happening:

• The Fed seems to be favouring sterilised asset purchases (Operation Twist 2) to another round of unsterilised purchases (QE3) - not least because we think it would not want to be seen to be fanning inflation expectations when energy quotes are likely to climb.

• Our ECB watcher, Elga Bartsch, is flagging upside risks to her call for another 25bp cut in 2Q as the oil price surge exerts upward pressure on the inflation outlook. And of course, last year the ECB hiked in response to the oil price rally then.

• Our Asia ex-Japan economist, Chetan Ahya, thinks that the rally in oil prices will delay repo rate cuts by the Reserve Bank of India, initially expected to commence in March; an April move would depend on the trajectory of oil and commodity prices, in his view.

• Our Bank of Korea watcher, Sharon Lam, sees risks to her call for a cut if inflation rises in the coming months.

Conclusions: We estimate the global wealth transfer from oil importers to oil exporters at current oil prices at around US$2.5 trillion for 2012 - 4.2% of oil importers' GDP or 3.6% of global GDP. This will likely be a drag on global growth, but would on its own not be sufficient to derail the recovery. Oil prices at US$150 could well tip the more fragile parts of the global economy into recession, however. We also worry that higher oil prices will act as a constraint on central bank easing, thereby resulting in less monetary support for the economy.

Box 1: The Global Effect of Oil Price Shocks

Higher oil prices first and foremost constitute a redistribution of wealth - and therefore demand - from net importers to net exporters (demand redistribution effect). This income transfer occurs because, in the short run, there is no escape for net importers: the responsiveness of energy demand to price (the ‘price elasticity') is low, since much of energy-consuming economic activity is ‘essential' (people have to drive to work, factories need to run, and so on). As a consequence, consumer spending on other items gets squeezed, as do corporate profits and therefore spending by firms.

Net exporters, the recipients of the income transfer from the net importers, are likely to save a substantial part of the income transfer. How much is saved and how much is spent depends crucially on whether the oil price increase is (perceived to be) permanent or transitory - the more transitory, the more is saved. In any case, the fact that at least some of the transfer is saved means that higher oil prices also, on net, take out demand from the global economy (demand destruction effect).

What happens to those savings? Part of it will be invested domestically. The other part will be invested abroad - oil producers' persistent current account surpluses are evidence of this. Some of these funds will be invested in other oil-exporting countries. But a substantial part of them will be invested in net oil-importing countries. In short, some of the initial income transfer is recycled into the purchase of assets of net importing economies - naturally, oil exporters obtain claims on net oil importers. So, the oil shock results in a reshuffling of the global ownership of assets - the asset market counterpart of the global wealth redistribution (asset recycling effect).

What happens to the part of the income transfer that is consumed? Again, a part of it will be consumed on domestic goods, and a part on imported goods. And once more, some of these goods will be imported from other oil producers, but most will be imported from net oil-importing countries. That is, part of the initial income transfer is reversed through goods imports from net oil importers (goods recycling effect).

So, from a high-level perspective, the oil bill is not a net negative for the global economy. The resources spent on purchasing more expensive energy do not disappear into outer space. Rather, a redistribution takes place - and as with every redistribution, it creates winners and losers. And even within the group of the losers, some will be relatively better off and some will be relatively worse off.

Box 2: The Barrel Bill and GDP Growth

How do oil prices and the barrel bill relate to GDP growth?

• Level versus change: We think that it is usually more helpful to look at the change in the barrel bill rather than the level. Why? The level of the oil import bill most of the time matters for the level of income available to an economy, not real GDP growth. Think of an economy that transfers a constant share of its income abroad every year. The consumption and investment decisions that determine GDP growth are then made on the basis of the post-transfer income. It is only when the share of income that goes abroad changes that spending plans have to be changed. If the share of the income transfer changes meaningfully, the resulting adjustment in spending can be disruptive to the economy. In particular, since spending on energy is ‘essential', other spending usually has to be reduced when energy becomes more expensive. (Of course, the level matters in the sense that, for a given change, the level determines the percentage - i.e., the relative - change in the bill.)

• Large versus small; permanent versus transitory: This is why large, permanent increases in the barrel bill matter more. Small increases only generate minor changes in level and pattern of spending; temporary increases can be absorbed by reducing saving.

• Supply versus demand: Last but not least, the driver of the (change in the) barrel bill matters. A strong world economy will boost oil demand, prices and hence the barrel bill; and vice versa when the global economy is weak. At the same time, an oil price and barrel bill driven by demand will act as an automatic stabiliser: they will slow the economy when it's strong and boost it when it's weak. On the other hand, a supply shock will increase the price of oil, decrease demand and increase the value of oil importers' imports, the barrel bill. (The latter increases because the response of demand to higher prices is muted - the ‘price elasticity of demand' for energy is low - hence the percentage price increase in the price outweighs the percentage decrease in demand.) The higher barrel bill has an impact on spending and hence reduces growth.

In short, it follows that while demand shocks increase prices and the barrel bill, the impact on GDP growth will be to slow it down gradually. Metaphorically speaking, in this case the price of oil acts like an elastic leash on the dog that is the global economy. If the dog surges ahead too quickly, the constricting effect of the leash will make sure it slows down - but it will not stop. Between 2003 and 2007, the real price of oil roughly doubled, with little evident harm to the global economy. A supply-induced increase in the price of oil (and barrel bill) would tend to have more serious effects. In the dog metaphor, an oil supply shock could act as a jerk on the leash, which could bring the dog to a halt.

The upshot: the most dangerous oil shocks are - you guessed it - large, permanent supply shocks. How large is ‘large' and how long-lasting is ‘permanent'? Here's an indirect answer. The current supply change is certainly ‘large' (Brent is up 17.5% year to date). And December 2013 oil futures trade at around US$113 (implying an average price of US$120 between April 2012 and December 2013) - long lasting but not ‘permanent'.

Box 3: Measuring the Oil Bill

The metric one uses depends on the purposes of the investigation. Here, we focus on the wealth redistribution that takes place in the global economy due to oil shipments from exporters to importers. Hence, we look at oil imports (equivalently: trade), rather than total oil consumption. It is only imports (exports) that imply a transfer (receipt) of resources abroad (from abroad). Correspondingly, to scale the global income transfer, we divide by the aggregate GDP of the oil-importing economies only.

The difference between imports and consumption is meaningful, both on a global and individual country level. Globally, consumption of oil for 2010 was around 87 mbd; imports on the other hand were around 54 mbd. This implies that out of the total consumption of oil, only around 59% crosses borders. The remaining 41% is nearly equally split between what oil exporters consume domestically (19% of global consumption) and what oil importers produce - and consume - domestically (22% of global consumption).

In terms of individual countries, some net exporters are important consumers, and some net importers are important producers. Russia and Saudi Arabia, the two biggest producers, together account for almost 7% of global consumption. Similarly, the US and China - both in the top three of global oil consumers - produce a substantial part of their total consumption domestically (in 2010, the US produced 39% or 7.5 mbd of its total 19.1 mbd consumption while China covered 45% of its 9.1 mbd crude oil needs from its domestic production of 4.1 mbd).

For full details and accompanying exhibits, see Global Economics: Barrel Bill (2012 Edition), March 14, 2012.

Official rhetoric is encouraging, yet progress on the ground is slow: Our conversations in Budapest revealed that there is a gap between official rhetoric and actual progress on negotiations. Hungarian authorities repeatedly say that they are keen to successfully complete negotiations with the EU/IMF. Yet, progress on the three infringement procedures, which we view as the precondition to the official start of negotiations, has been slow relative to our expectations.

A fundamental disconnect: something may need to give: There seems to a feeling among the authorities that the negotiations with the EU can start independently of the infringement procedures. Recent comments by Minister Fellegi (Chief Negotiator) suggest that the authorities think that Hungary could take the contested issues all the way to the European Court of Justice, while at the same time negotiating with the EU (and the IMF) on an assistance package. This stance might be too ambitious, we think: Hungary may need to backtrack on these issues if it wants to get a deal. And while it is in everyone's interest to reach an agreement, Hungary would benefit from the agreement disproportionately more. It therefore follows that it has the highest incentive to make concessions.

What exactly are the contentious issues? From the point of view of the European Commission, the three infringement procedures launched on January 17 have not been resolved. Two of them were taken to the second stage of the EU infringement procedure (the retirement age of judges and the independence of the data protection authority); in two other areas (NBH independence and the independence of the judiciary), the EC requested further clarifications. Hungary has one month (April 7 deadline) to reply to these issues.

How important are these issues? Very important, we think: There is a great deal of ambiguity over whether these infringement procedures need to be put to rest before official negotiations on an assistance package can begin. Our assumption and understanding is that they do. The Hungarian authorities appear sometimes to want to separate the issues of the infringement procedures and the funding facility. We do not think they will be successful. Because of the unorthodox conduct of economic policy over the last two years (one-off taxes, overhaul of the private pension system, unilateral changes to FX mortgage contracts), Hungary may not enjoy a great deal of goodwill among European policy-makers, we think. It therefore seems unlikely to us that they will be willing to cut Hungary much slack.

Once negotiations do start, the authorities may need to be a lot more flexible than they are now: We think that these preconditions represent a significant hurdle to the start of the negotiations. Yet, the actual negotiations themselves could also be quite tricky. The IMF may have its own issues with the new NBH Act, for instance the excessive transfer of power from the Executive Board to the Monetary Council (see recent Article 4).

What could the IMF ask for? In addition, while the Fund is unlikely to ask Hungary to undo its flat tax, it is pretty clear that the new tax system is creating severe distortions in the economy: to compensate low-wage earners for their loss of income (tax credits were abolished in January 2012), the government decided to raise the minimum wage by 18%, a move that in such a weak labour market could well translate into further layoffs. At a minimum, the Fund is likely to ask the government to be willing to revisit these issues in the coming months. Whether the authorities are ready to accept any changes, even in principle, remains to be seen.

Risks of delay are rising: Despite the positive headlines that we see on the wires, our distinct feeling is that so far progress towards a deal has been slower than we had hoped for after our last visit (see Budapest Trip Notes, February 2, 2012). In terms of the incentives to get a package, nothing has changed, in our view. Despite the recent improvement in risky assets, the case for a precautionary line remains compelling, we think.

June now seems the earliest a deal can get done: We previously thought that a deal could be done by April, but have noted the lack of progress during our meetings. We now think that in the best case scenario, a deal can be struck by June. This assumes that the Hungarian responses by April 7 are accepted by the EU (some time in April), and then formal negotiations can begin. These may take one or two months. If progress remains slow, we believe that a delay to the summer months (July/August) is possible. In the case of a further rebound in risk, the authorities may even be tempted to abandon the negotiating table, which could have negative consequences, in our view.

How necessary is a deal, really? We are often asked how necessary a deal is. Our strategists estimate that there are approximately €3.4 billion of IMF loans coming due between now and year-end, which together with FX bonds worth €1.5 billion takes the total government redemptions in FX to just under €5 billion. Given that the bulk of IMF money drawn under the previous package (€6 billion out of €9 billion) still sits in reserves, probably NBH reserves can be used to meet IMF repayments. Also, the AKK has cash reserves of €2.5 billion in foreign currency and just over €2 billion in local currency (end-February data). In addition, it likely still has around €2 billion of FX assets (our estimate) from the previous nationalisation of pension funds. And of course, the AKK could always borrow in local currency and swap this for FX reserves if it needed extra liquidity (cash FX reserves stand at €31 billion). In short, it does not look to us as though the government's need for FX is so extreme that, if the assistance package did not go through, the government would face FX liquidity issues.

Very necessary, we think: The above analysis is only partial: the government sector is not the biggest source of external repayments this year. Rather, the banking system should have a lot of demand for FX, with estimated redemptions worth €18 billion (short-term external debt + medium and long-term debt maturing). Given that deleveraging is under way, the banks may demand significant amounts of FX, which may translate into a reserve loss for the NBH (if it chooses to meet that demand) or severe currency weakness. An assistance programme is needed to provide a framework for the banks to slow down deleveraging. And of course, the programme would also reassure bondholders about the fiscal outlook. Finally, an EU/IMF package would also provide investors with greater clarity about macro policy, and in all likelihood strengthen the currency, lower the cost of capital and trigger monetary easing by the NBH. In short, it could set in motion a virtuous cycle which can boost both confidence and growth.