Cursed Resources? Political Conditions and Oil Market Outcomes.

Author:Metcalf, Gilbert E.
Position:Report - Statistical data
 
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  1. INTRODUCTION

    Development levels vary considerably across countries, and explaining why these differences exist is one of the central questions in economics. While scholars have long hypothesized that political institutions play an important role (see, e.g., North (1981)), a recent literature has made progress identifying a causal impact of institutions on cross-country differences in macro-economic outcomes. (1) Still, the mechanisms by which specific institutions affect economic outcomes to a great extent remain a "black box" (Acemoglu, Johnson and Robinson (2001)--hereafter AJR--p. 1395).

    This paper focuses on the influence of institutions on one particular industry: crude oil production. We document a pronounced negative effect of good political conditions on volatility in oil production, and this result is robust to using several different measures of political conditions. We also address the potential endogeneity of political structure, as suggested by the literature on the "resource curse." We estimate two-stage least-squares regressions where we instrument for recent political institutions using institutions before oil was commercialized. We find that the negative relationship persists in these specifications. We also evaluate whether other macroeconomic differences across countries affect oil market outcomes, including financial openness and legal formalism. None of these factors has a significant effect on volatility once we control for institutions.

    It is important to acknowledge that a country's oil production may not necessarily be inefficient if it is volatile. To allow for this, we also construct volatility measures that control for market factors which should drive changes in a country's oil output, and our results are robust to using these alternative measures.

    Ideally, we would also like to measure oil output controlling for the natural resources available to the country, as this is analogous to studies that examine factors contributing to differences in economic development. With this goal in mind, we also examine the link between political institutions and a country's average production as a share of its proven reserves. We find that countries with better political institutions produce a higher share, although we devote less attention to these results since the data on reserves are self-reported in some cases and could be systematically biased. Finally, we show that political institutions lead to volatility in the number of active wells, suggesting that the volatility is less likely to be driven by physical characteristics of a country's oil fields.

    Oil production provides a particularly convenient lens to view the possible microeconomic foundations for macroeconomic outcomes as oil is a commodity sold on a world market. This means that production decisions within a country should be driven by world demand and not local macroeconomic conditions. Was this not the case, our results would be less interesting as they could simply reflect the effect of political institutions on overall macroeconomic activity. Since oil demand is worldwide, however, we can be confident that our results reflect supply-side factors and not demand-driven output volatility.

    Another reason that oil is well-suited to this analysis is that the unit of output (a barrel of oil) is of essentially homogenous quality and is consistently measured across countries. Finally, rich data are available on oil production and its determinants, such as reserves and the number of wells.

    By documenting that political institutions affect outcomes in a particular industry, our results provide insight on how institutions affect aggregate economic output. For example, they suggest that while political institutions may work by influencing structural factors, such as by promoting a well-developed commercial sector or less reliance on agriculture (see, e.g., Duarte and Restuccia (2010)), these cannot be the only mechanisms at play as institutions have effects within an industry. Although our results cannot address this hypothesis directly, they are consistent with the idea that well-functioning political institutions support efficient investment in crude oil production and prevent wars, domestic conflicts and nationalization episodes, which can severely limit a country's oil production capabilities. We support this interpretation with a detailed analysis of nearly 150 episodes when countries' oil output fell significantly. This analysis strongly supports the conclusion that poor political institutions undermine production, and provide insight on the mechanisms leading to the production declines.

    Our results also provide insight on world oil markets. Like many energy markets, oil markets are characterized by extremely inelastic short-run supply and demand, meaning that even small fluctuations in either can lead to large swings in price. While much has been written about how systematic shifts in oil demand or supply affect prices (see, for example, Hamilton (2009) and Kilian (2009)), less is understood about the underlying determinants of short-run changes in supply.

    Our results imply that political institutions in the countries endowed with oil reserves affect the volatility, and perhaps the level, of its production. To the extent countries with poor political conditions will have less stable production of other natural resources, our results suggest a useful metric for comparing different energy sources. As U.S. policymakers attempt to drive shifts to new, alternative energy technologies, it is useful to be able to make these comparisons.

    To explore the implications of our results for world oil markets, we construct annual, worldwide statistics that summarize the political institutions of oil-producing regimes. Generally, our indexes depict a reduction in the political conditions of oil producing countries between 1965 and 1978, followed by an increase that peaks sometime in the late 1990s or early 2000s, depending on which index is considered. In recent years most of the indexes show a modest decline starting around 2003. (2)

    We next decompose the measures into "production share" and "internal conditions" indexes to show how changes in the aggregate measures are driven by changes across countries in their share of world oil production and changes within countries in political conditions. In the early part of our sample, changes in oil political conditions were mainly driven by changes in the production share, as Middle Eastern countries accounted for a larger and larger share of total production. Recent trends, however, appear to be driven by changes in internal conditions in addition to changes in the location of oil production.

    We show that the higher the share of oil coming from countries with poor political conditions in any given year, as measured by the decomposed "production index," the higher is the volatility of oil prices in that year. Within-country changes in political conditions, as measured by the decomposed "internal conditions index," if anything have the opposite effect on oil price volatility, suggesting that it may take time before short-run changes in political conditions impact oil production.

    While short-run production volatility within one country's borders may be quickly counteracted by adjustments in other countries so that any resulting price volatility will be short-lived, there are reasons to be concerned about the volatility. For one, price volatility makes business planning difficult and raises the cost of hedging risk. It is particularly difficult for energy-dependent industries such as the airlines and automakers. It also raises concerns for many that speculation is contributing to price volatility and spikes causing many to call for tighter regulation of energy markets. (3) Finally, we test whether countries with poor political conditions are more likely to cut back on oil production when prices are high and/or other countries are also cutting back.

    The next section of the paper discusses the mechanisms by which political conditions might affect oil markets. Section III presents our main empirical findings, documenting the negative relationship between political conditions and oil market volatility. Section IV interprets our findings and analyzes their implications for price volatility in world oil markets. We also discuss why our findings probably do not support an "energy-security" based argument for government intervention in energy markets. We conclude in section V with some thoughts on the lessons to be drawn from this analysis as well as possible future extensions of this research agenda.

  2. BACKGROUND

    In this paper we seek to identify the role that political conditions play in driving the volatility of oil production. While the considerable literature debating the existence of a "resource curse" focuses on the causal relationship between a country's oil wealth, or wealth from other natural resources, and macroeconomic and political outcomes (see van der Ploeg (2011) for a comprehensive survey), there has been little focus on the role governance plays in affecting oil supply. (4)

    We discuss the resource curse literature briefly to motivate an important point about endogeneity. Within the extensive literature on the resource curse, a subset of papers consider whether "oil and mineral wealth tends to make states less democratic" (Ross (2001), p. 328). (5) These papers (and others in this literature) highlight the point that we cannot treat political institutions as exogenous in any analysis of the role political conditions play in affecting oil supply, and they emphasize the need to instrument for a country's political conditions.

    Turning to the effect of institutions on energy markets, Bohn and Deacon (2000) consider how ownership risk affects the exploitation of natural resources in countries. They find that higher ownership risk decreases oil drilling and oil production whereas higher...

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