Oil price and exchange rate volatilities: implications on the cost of living in an OPEC member country—Nigeria

• DOI: http://doi.org/10.1111/opec.12157
• Date: 01 December 2019
• Author: Sylvester Ike Udabah,Chimaobi Valentine Okolo
• Published date: 01 December 2019

Oil price and exchange rate volatilities:

implications on the cost of living in an OPEC

member country—Nigeria

Chimaobi Valentine Okolo* and Sylvester Ike Udabah**

*Research Fellow, Department of Economics, Enugu State University of Science and Technology, Agbani,

Enugu State, Nigeria. Email: chimaobi.okolo@gmail.com; valentine.okolo@esut.edu.ng

**Professor, Department of Economics, Enugu State University of Science and Technology, Agbani, Enugu

State, Nigeria. Email: sylvester.udabah@esut.edu.ng

Abstract

This study investigates the dynamics of crude oil price and exchange rate volatilities, and

implications of these volatilities on the cost of living in Nigeria. Consequently, it provides two key

innovations: (i) It augments the structural equation modelling to include three stage Generalised

Autoregressive Conditional Heteroscedasticity (GARCH) model; (ii) It employs this methodology

to uniquely measure the significance of simultaneous paths from Bonny Light crude oil price

predictors through exchange rate of the Naira vis-

a-vis the USD to consumer price index in

Nigeria. It finds that crude oil price and exchange rate volatilities did not significantly pass-through

to the consumer price index in Nigeria. More importantly, it shows that information is a significant

determinant of future volatilities. Therefore, the media becomes crucial in predicting exchange rate

and inflation in Nigeria.

1. Introduction

Similar to most oil exporting countries in Africa, the Nigerian government directly

receives the financial benefits of crude oil exports. Consequently, fiscal spending and

macroeconomic policies depend on oil price, since the necessary funds for government

expenditure come from the revenue gotten from oil export (Rosser and Sheehan, 1995).

In such an economy, an oil price shock could easily be transmitted through exchange rate

to cause economic instability due to the variations in oil revenue. According to Kilian

(2006), when a country has favourable terms of trade, oil revenue can easily be used to

efficiently finance expenditure by government, which otherwise would lead to waste as

is mostly the case with fiscal expansion and inefficient public financing. The

unproductive system of inefficient public finance and fiscal expansion, over time,

JEL classification: E31, F13, F31, F41.

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makes the economy more open and subjected to oil price shocks, especially wher e

capital market has certain imperfections (Anashasy et al., 2005). However, when there is

a downturn in the price of oil without a corresponding immediate downturn in the level

of spending of large public sectors, the economy faces substantial deficits.

This has been a recurrent incident in Nigeria, most notably during the global

economic meltdown, between 2008 and 2009, and more recently in 2015, when the

economy plunged into recession. Nigeria witnessed a sudden decline in Bonny Light

crude oil price from the peak of US$147 per barrel in July 2008 to US$40 per barrel in

February 2009 and below US$40 between second and third quarter of 2015. Also, the

economy experienced depreciation of currency from ₦118/$1 to ₦145/$1 and to ₦345/

$1 (official rate) in the same period, while parallel exchange rate soared above ₦450/$1

in quarter three of 2016. As predicted by Ogiri et al. (2013), rise in the volatility of real

oil price created market uncertainties that prompted companies to defer investment,

which would have quickly boosted economic growth and wellbeing of the populace.

Additionally, decreasing oil price also had negative implications for the Nigerian

economy, being largely dependent on importation of much of its consumables, including

refined crude oil products (such as petroleum motor spirit, automated gas oil, distilled

petroleum kerosene etc). The economy experienced depreciating currency value, rising

cost of living and other negative macroeconomic implications following the economic

recession that started in 2015. Notwithstanding the decline in oil earning and sudden rise

in exchange rate in 2015 Nigeria continued to import foreign goods, including refined oil

products, causing supply side negative effect. This resulted in the depletion of the

stabilisation fund and increase in debt burden as government sought for economic

recovery and growth in succeeding fiscal years. Although earning began to increase as

oil price gradually picked up, cost of living remained high due to weak production

capacity insufficient to satisfy growing demand for domestic goods. Consequently,

prices of locally produced goods took an upward trend, further worsening the poverty

incidence in Nigeria. It is against this backdrop that this study set out to: (i) evaluate the

impact of oil price and exchange rate volatilities on the cost of living in Nigeria; and (ii)

empirically examine the significance of the pass-through from oil price to cost of living.

Comparing relative prices of commodities, Regnier (2007) observed that the oil price

is more volatile than the prices of other commodities. Focusing on WTI/Brent oil price

spread, Liu, Reid and Dmitry (2018) utilised physical market determinants, such as oil

supply, demand and oil inventory in the United States and Norway to explain that oil

prices respond mainly to flow supply shocks, flow demand shocks and speculative

demand shocks. While this paper is similar to that of Liu et al., (2018) in its adoption of

oil demand and supply, it is distinct in the focal oil product (Bonny Light), its unique

adoption of OPEC supply and non OPEC supply of crude oil, and the innovative

methodology applied in the study. The work of Coudert et al. (2013) gives insight on the

OPEC Energy Review December 2019 ©2019 Organization of the Petroleum Exporting Countries

414 Valentine Okolo and Ike Udabah