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Managing and Harnessing Volatile Oil Windfalls

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Abstract

Three funds are necessary to manage an oil windfall: intergenerational, liquidity, and investment funds. The optimal liquidity fund is bigger if the windfall lasts longer and oil price volatility, prudence, and the GDP share of oil rents are high and productivity growth is low. The paper applies the authors’ theory to the windfalls of Norway, Iraq, and Ghana. The optimal size of Ghana's liquidity fund is tiny even with high prudence. Norway's liquidity fund is bigger than Ghana's. Iraq's liquidity fund is colossal relative to its intergenerational fund. Only with capital scarcity, part of the windfall should be used for investing to invest. The paper illustrates how this can speed up the process of development in Ghana despite domestic absorption constraints.

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Notes

  1. Whenever we refer to oil, it should be interpreted to refer to natural resources (gas, diamonds, copper, bauxite, phosphate, and so on) more generally and could also be interpreted as remittances (which decline as migrant workers return home or lose connection with the home country) or foreign aid. Oil is thus used as a shorthand for a windfall of foreign exchange and oil price as a shorthand for commodity prices.

  2. Earlier work uses a model of a small open economy that exports exhaustible resources to quantify optimal precautionary saving in response to volatile resource prices and demonstrates that current account balances of countries with a greater weight of resource revenue to future income are bigger (Bems and de Carvalho Filho, 2011).

  3. Limited commitment incentivizes the government to pay down external debt along the adjustment path (for example, Cohen and Sachs, 1986; Aguiar and Amador, 2011). Debt overhang can exacerbate volatility (Aguiar, Amador, and Gopinath, 2009).

  4. Some share of oil windfall, typically, ends up in private hands, which may not end up in the funds administered by the government or independent authorities. We consider optimal size of the “funds” for the economy as a whole.

  5. This is related to the celebrated Hartwick rule which says that oil rents should be saved, so that exhaustible assets under the ground are fully transformed into assets above the ground (Hartwick, 1977).

  6. In many poor countries the share of petroleum consumption in household income is high, income and price elasticities for petroleum demand are low and households are relatively risk averse, in which case the risk aversion effect dominates the effect of substituting away from petrol if its price is high and towards petrol if its price is low, so that consumers benefit from petrol price stability (for example, Turnovsky, Shalit, and Schmitz, 1980).

  7. Bems and de Carvalho Filho (2011) offer a discrete-time approach for dealing with oil price uncertainty and precautionary buffers, but do not deal with capital scarcity and productivity growth.

  8. We thus avoid the heteroskedasticity problems, which would arise when estimating a Geometric Ornstein-Uhlenbeck process (Dixit and Pindyck, 1994) and exploit the fact that Equation (7) can be written as a standard homoskedastic AR(1)-process after a logarithmic transformation.

  9. These optimality conditions extend the results of van der Ploeg (2012) to a stochastic setting.

  10. The fund comprises two separately managed funds. The main fund is the Government Pension Fund Global renamed 1 January 2006 and is part of the Norwegian Central Bank (formerly The Government Petroleum Fund established in 1990 and receiving money since 1996). It manages the surplus wealth produced by Norwegian petroleum income (taxes and licenses) and is the second largest pension fund in the world. Since 1998 the fund was allowed to invest up to 40 percent of its assets in the international stock market (60 percent from 2007). The other fund is the Government Pension Fund Norway renamed 1 January 2006 (formerly The National Insurance Scheme Fund established in 1967) and is much smaller.

  11. The Fund also allows Norway to stabilize the economy across the business cycle, since the 4 percent is meant to be an average over the business cycle. Since value of the Fund varies with world asset markets, the government has the discretion to deviate from the 4 percent rule when it deems this necessary.

  12. We group oil and other liquids only excluding gas as liquids, henceforth referred to as oil, which follows the definition of the Norwegian Petroleum Directorate (2011).

  13. From Norway's official long-term forecast http://www.ssb.no/folkfram_en/main.html.

  14. We use a historical annual series for the price of crude oil (BP, 2012), expressed in 2012 prices using CPI data for the U.S. (from OECD Economic Outlook No. 91). We use the UK natural gas price for the period 1996–2011(BP, 2012), which seems the best available location. In the absence of generally available data for Europe for the period 1971–95, we use the U.S. Natural Gas Wellhead Price for that period (USEIA, 2012). As all figures are in U.S. dollars to compare between countries. Accordingly, we use U.S. inflation data to obtain the real oil price and, in doing so, we abstract from purchase power parity considerations.

  15. Excluding recent crisis years when rates in some safe countries have plummeted to below zero, we would have obtained 3.7 percent. We do not take the 2.4 percent of the Norwegian SWF as this may be low due to the dominant effect of the downturn in recent years. Bems and Carvalho Filho (2011) also use a high rate of return of 4 percent.

  16. Hence, ρ*=r*g/σ=1.4 percent, 2.4 percent, and 2.0 percent for Norway, Iraq, and Ghana, respectively if σ=0.5.

  17. The coefficients for the effects of the public and publicly guaranteed debt to GNI, the ratio of central bank reserves to GDP and the probability of default on the log of the interest rate spread are, respectively, 1.89, −4.14, and 0.296.

  18. We approximate oil rents in efficiency units by N(t)=3.8exp[−0.068(t−2012)], so N 0 = U.S.$3.8 billion and oil rents decline in 2012 dollars at 2 percent per year (as n+g=4.8 percent). This matches 2012 in situ oil wealth of U.S.$42 billion and the annuity value of oil wealth in efficiency units as 2.2 percent of that, that is, NP(0)=0.93 billion U.S.$/year.

  19. The optimal policy simulations are obtained from a linearization of the state-space model.

  20. Note that the public investment rate, I/S=2(1−PIMI)/PIMI, and the social price of public capital, q=1+φI/S, are negatively related to the PIMI.

  21. For Iraq the windfall is so large that assets per capita do not start to decline until 2050 in the base case if we set r**. The consumption increment in 2012 is now 5.8 times nonresource GDP while the size of the windfall in 2012 is 6.5 times nonresource GDP. Given the greater need for precautionary saving as future generations are no longer much richer, consumption in 2012 is reduced by 1.2 times nonresource GDP in the base case (so the total consumption increment is 5.8−1.2=4.6 times nonresource GDP), thus leaving approximately 70 percent available for consumption.

  22. Normally, future growth cannot be used as collateral for substantial borrowing, but oil-rich countries such as Iraq have sufficient oil income readily available. Whether we smooth consumption in efficiency units or in per capita terms is ultimately a normative question about how large the social discount rate should be.

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*Ton van den Bremer is an Engineering PhD student with a MPhil in Economics at the University of Oxford; Frederick van der Ploeg is Professor of Economics at the University of Oxford and Research Director of the Oxford Center for the Analysis of Resource Rich Economies. This research was supported by the BP-funded Oxford Centre for the Analysis of Resource Rich Economies and the Fiscal Affairs Department of the International Monetary Fund. The authors are grateful for the detailed comments received on an earlier version that was presented at the CBRT-IMFER Conference on “Policy Responses to Commodity Price Movements,” Istanbul, April 6–7, 2012. The authors also thank their colleagues Torfinn Harding and Samuel Wills for their help with the oil windfall data for Norway and Ghana and Iraq, respectively, and are grateful for the comments of Pierre-Olivier Gourinchas, Thomas Helbing, Ayhan Kose, Kamil Yilmaz, and two anonymous referees.

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van den Bremer, T., van der Ploeg, F. Managing and Harnessing Volatile Oil Windfalls. IMF Econ Rev 61, 130–167 (2013). https://doi.org/10.1057/imfer.2013.4

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