ENERGY

Introduction 
With price of gasoline approaching four dollars per gallon, the issue of US dependency of imported oil is reemerging. If you think that United States dependency on imported oil is a problem, consider this; the oil exporting countries depend much more heavily on oil revenue for their public spending. For instance, nearly 80% of Iran’s exports income comes from oil and almost half of its fiscal revenues according to the Energy Information Administration statistics. Oil exports generate as much as $50 billion per year in total for Iran.

If Iran’s oil production capacity remains stable its oil revenue continues to rise drastically due to surging oil price. However, there are some indications that Iran’s production capacity may be diminishing as much as 5% per year according to some analysts. If such speculations are true, the growth of Iran’s oil revenue will decelerate through time.

But the troubling issue for the government of Iran is not the extent of oil revenues but the fluctuations in price of oil that have been more intense in recent years. Unanticipated fluctuations create uncertainty for Iranian government when it comes forecasting its long term budget. Because a lion share of government expenditures are financed by oil revenue, oil price volatility imposes serious disruptive effects on public spending. Price of crude oil is established in commodity markets primary by the interaction of global supply and demand. On the one hand, as a member of OPEC, Iran has to honor the quota system imposed by the cartel organization. Inability to control price or set their supply has created a serious challenge for OPEC members in general and for Iran in particular making it difficult for its government to project its own long term revenues accurately.

During the last two decades there have been considerable changes in economic policies of GCC (Gulf Cooperation Council) countries forcing these countries to smooth out the effects of the abrupt fluctuations in oil price. Following the persistent increase in price of crude oil, especially after 1973, the government policy-makers in these countries decided to utilize the additional oil revenue by investing it in the infrastructure of their countries thus boosting their economic growth. On the contrary, during the period of declining oil price, the government has been forced to cut its investment expenditures, because they are entirely financed by oil revenues, and to rely more on non-oil sources of revenue for its non-developmental expenses.  

Generally speaking, the unanticipated fluctuations in price of strategic commodities like crude oil results in detrimental effects for the Iranian economy. As such, the investigation into the effect of oil price volatility and government expenditures is certainly of great importance and deserves profound research. Because oil revenue is mainly devoted to long term investment projects, the surge in price of oil and consequent increase in government revenues do not necessarily result in higher level of welfare for Iranian people in the short term. If price fluctuations are orderly and predictable, the government’s revenues grow gradually in a predicable fashion and can be utilized in an efficient way. There is, therefore, no need for concern.

However, if the changes are abrupt and intense, as they have been during the past few years, they create a difficult challenge for government. Strong increase in price of oil, for example, encourages government to spending lavishly and hastily on unnecessary projects, such as massive public subsidy, thus promoting inefficiency. The sudden injection of additional revenues into the market disturbs the overall economic equilibrium and sever inflation will ensue. Conversely, sudden decrease in such revenues makes the government incapable of fulfilling its commitments when it comes to finishing its investment projects on time. As a result, it may be forced to operate on deficit.  

Government spending, of course, is not always wasteful. Investment in infrastructures of the country, if done efficiently, can generate external benefits for private sector thus facilitating national output the growth of the economy. Consumptive spending, however, can be wasteful and inefficient especially large-scale subsidy programs sponsored by government in Iran.  

Another important point that deserves attention is that the effects of oil-price fluctuations on government current expenditures are not the same as their effects on developmental expenditures. Current expenditures such as employees’ salaries and government purchases of ordinary goods and services are mostly financed by tax revenues. If tax revenues are not adequate, then oil money is used as supplementary source of financing. Developmental expenses such as purchases of capital goods, building a hospital, construction of highways, air ports, bridges, etc. are financed totally by oil revenues. Distinction between these two types of expenditures really matters. While current spending has temporary effects on the economy, developmental expenditures have long lasting positive outcomes for the economy because they generate sources of long term income that is necessary for economic growth.  

The Sources of Price Volatility 
Despite the relative stability during earlier decades, price of crude oil has experienced resilient volatility since 1973 following the energy crisis and many other crucial events that have occurred since then. Many factors believed to be responsible for the growing volatility of price of crude oil. Before exploring these factors, we should notice a priori that the market for crude oil is quite complicated because crude oil is a globally demanded product traded in commodity markets across the world by thousands of brokers and dealers. In addition, there is no common consensus among economists concerning the nature and the structure of crude oil market.

When it comes to the sources of volatility in oil price, the immediate focus is on OPEC as the culprit. Some economists as well as many politicians blame OPEC as the still dominant authority in oil market. I believe, however, that assertion is inaccurate and many other factors play a greater role in price fluctuations. A few of them will be examined below.  

For OPEC to be the determining force in oil market, it has to have the power to control a substantial portion of the oil market and be able to enforce strict quota system on its members. Its share of oil production currently is limited to about 50% of the global market according to the information provided by EIA. This is, indeed, small relative to the market share of other world’s commodity cartels such as; the International Tin Council, International Coffee Organization, International Cocoa Agreement, international cartels on diamond, rubber, copper, etc. These cartels have also enforced stringent quota system since day one of their establishment with persistent monitoring and punishment mechanism.

OPEC, on the other hand, has not such an apparatus. In addition, the OPEC members do not pursue a common objective of price control. The development of non-OPEC sources has intensified competition in crude oil market further diminishing the controlling power of OPEC. When it comes to price setting, the OPEC countries are very much constrained by non-OPEC producers such as; Russia, Canada, Brazil, and Norway who set the price according to market conditions and OPEC countries have to put up with that price. In other words, OPEC members are forced into the position of “price taker”.   

There has not been any evidence of successful collusion among OPEC members in recent years either. To have succeeded, members should have pursued a common interest and a common goal. OPEC countries have been following different goals however, many of them have unfriendly attitudes toward one another. Their needs for oil revenue and their dependency on oil money are also different. The possibility of mutual cooperation under such circumstances has been almost impossible.

In addition, in all OPEC member countries the oil industry is owned and operated by government and is not subject to market-imposed discipline. Saudi Arabia, for example, used to maintain a huge excess capacity that allowed this country to regulate the abrupt fluctuations in world supply thus price if deemed desirable.  In other words, Saudi Arabia played the role of “swing producer” when necessary to stabilize price.

When there was a political unrest in Nigeria, turmoil in Venezuela, revolution in Iran, or war in Persian Gulf that resulted in plummeting oil production, it was the Saudi Arabia that released a hefty amount of oil to replenish world supply and kept prices from soaring. However, the spare capacity of OPEC countries has been reduced to a very low level in recent years. Without adequate excess capacity that can serves as a balancing factor, the power of OPEC to stabilize the oil price has grown weaker to a great extent resulting in further price volatility.

In my judgment, the following factors have played a role in wild fluctuations in oil price in recent years.   

   1. The change in the structure of oil market after 1970. Before 1970, the oil market was kind of collusive oligopoly controlled by huge oil companies: Standard Oil of New Jersey, Royal Dutch Shell, Anglo Persian Oil Company, the Gulf Oil, and Texaco, etc. These companies, known as seven sisters had the huge market power on production, refining, and distribution of oil. The oligopoly structure of the market precludes them from price competition and provided them with a strong economic incentive not to increase the price. They kept price stable and low because they made huge profit from the variety of products derived from crude oil. After 1970’s, however, the market power swayed toward oil-exporting countries because of a wave of nationalizations in oil exporting countries that led to the declining influence of seven sister companies and disintegration of oligopoly structure in the oil market.

2. Major political events such as US invasion of Iraq in 1990 and again in 2002, unrest in Venezuela, and especially revolution in Iran and the removal of the Shah who acted as the leading force of OPEC and the guardian of the US interests. These events resulted in escalation of violence and continuous tension in Middle East raising the probability of disruption in supply of crude oil. The resulting uncertainty is still lingering around.

3. the immense complexity of oil market, industry analysts are not able to forecast supply and demand accurately, thus creating additional risk and difficulties in predicting the direction of the market. Lack of reliable data on demand and supply create an atmosphere that has become a breeding ground for rumor and inaccurate information.  In addition, the popularity of futures and commodity-based contracts in recent years has contributed massively to price volatility. These innovative products are indeed the pivotal forces in setting up the commodity prices including crude oil. Prices in these markets are influenced by wide variety of factors including market fundamentals, traders’ expectations, and barrage of information coming to market on a nonstop fashion. When it comes to price of crude oil, it seems that the political as well as psychological factors also play a determining role. Too much speculations about possible direction of supply and demand by market participants has intensified price volatility in crude oil market especially during the past few years.

Our Empirical Findings
As mentioned previously, the unpredictable fluctuations in price of oil have unfavorable influence on current government expenditures in Iran despite the fact that such expenditures are mainly financed by tax revenues. The statistical results of our research - conducted with the collaboration of some of my colleagues in Iran – revealed that a 1% increase in price volatility causes such expenditures to decline by 0.96%. The almost proportional change is due to the fact that such expenditures are divisible. Therefore, they can be modified easily if there are changes in oil price and the resulting revenues. Because such expenditures are considered necessary, government may not have much discretion.

In case that projected oil revenues do not materialize, government has no choice but to cut such expenditures in line with attainable revenues. Otherwise, operate on deficit. With deficit spending, government is forced to borrow from central bank by resorting to printing more money. Such a policy is considered extremely inflationary unless government lowers its expenditures elsewhere drastically to offset the inflationary pressure.  

When it comes to developmental expenditures negative but stronger effect has been indicated by our findings. A 1% increase in oil price fluctuations forces such expenditures to drop by 1.16% hampering the ability of government to invest in long term projects especially the countries infrastructures. The more than proportional effect can be due to the fact that such projects are not divisible and some of them may be totally abandoned or down sized as a result of insufficient revenues. Such unwelcome choices may lead to slower economic growth and increase in unemployment rate.  

As can be surmised from our finding, the effect of oil price volatility on developmental expenditures is more pronounced because these projects are entirely financed by oil revenues. However, a substantial portion of current expenditure is paid for by tax revenue. Developmental expenditures are not also flexible as mentioned earlier. They change in a lump-sum fashion. In addition, a less socially painful method for government to cut its costs is to lower the developmental spending. Given the broad based subsidy programs especially for gasoline and given the fact that Iranian population is very young, the current expenditures are unavoidable to a great extent.  

It seems logical to assume that increase in price of oil enables government to boost its total expenditures. This in confirmed by our findings which show a statistically positive and significant correlation between price of oil and government spending. A one percent change in price to the up side causes a 0.75% increase in current expenditures and a strong surge in developmental expenditures, 1.2%. Because current expenditures are primarily financed by tax revenues, a one percent change in tax revenues causes a disproportionate effect on such spending, a whopping 1.50%.

Given our findings, we believe that attention to the following issues is necessary:

1. more research should be done about the public investment projects before they are implemented, better planning of these projects, and utilization of the techniques that allows government to shorten the completion time thus minimizing their vulnerability to oil revenues.

2. using the oil revenues primarily to rebuild the infrastructure of the country and/or investing them in projects whose profitability is established a priori

3. exploring the possibility of investing a portion of oil revenues in financial assets in foreign countries with well-established financial system as well as strong and stable economy

4. keeping the oil money in dominant foreign currencies and ending the conversion of oil revenues into domestic currency, Real. And, utilizing hedging and diversification techniques to minimize the risk of oil price volatility as well exchange rate fluctuations

5. government should pursue more aggressively the privatization policy and downsize its braod-based subsidy programs. By doing so, government can free a huge amount of funds that can be allocated to more efficient projects with long lasting benefits for the economy