The Impact of Oil Price Volatility on Welfare in the Kingdom of Saudi Arabia: Implications for Public Investment Decision-making.

• Author: Pierru, Axel

1. INTRODUCTION

   Maximizing economic welfare is a primary objective of policymakers worldwide. However, under the reasonable premise that agents are risk averse, the uncertainty surrounding the economic growth rate has a social cost, usually determined as the loss of welfare that a representative agent is willing to incur to get rid of fluctuations in his consumption or income. Though this cost may be negligible in certain economies, this may not be the case for countries that rely on commodity exports revenue. Since the Kingdom of Saudi Arabia is the world's largest oil exporter, a considerable portion of its gross domestic income and government revenues depends on the crude oil price. As a consequence, Saudi domestic income and aggregate consumption are likely to be variable throughout time and significantly correlated with the crude oil price. In recent years, oilrelated exports have on average represented around half of the Saudi nominal Gross Domestic Product (GDP). Over the last two decades, the standard deviation of changes in the annual average price of Arabian Light crude oil is 25%. A one-standard-deviation shock to the oil price therefore represents an income shock equivalent to 12.5% of Saudi GDP, which is high relative to the GDP volatility in most countries.

   For public investment decision-making in Saudi Arabia, this raises the question of the risk premium associated with the crude oil price. In other words, when assessing a public project's net present value, by which amount should its expected oil-related cash flows be adjusted? This adjustment quantifies the social cost--or benefit--generated by the correlation of these cash flows with economic growth. Considering this risk premium may affect the decision making pertaining to energy-related public projects in Saudi Arabia.

   The sustainability of the current path of Saudi domestic oil consumption has recently been questioned (e.g., Gately et al. (2012)). To curb the growth in domestic oil demand and thus free additional oil for export, various options are currently being considered by Saudi authorities, especially the diversification of the Saudi energy mix and investments in energy efficiency. In particular, the Saudi power sector relies almost exclusively on oil and natural gas. Developing new energy sources for power generation would therefore help preserve oil exports, as in some regions of the Kingdom the marginal power generation technology is based on the combustion of oil products. Saudi Arabia thus announced (1) a solar power generation capacity target of 41 GW by 2032 in an attempt to decrease oil consumption in the electricity sector. The Kingdom is also exploring the possibility of introducing nuclear power capacity in its energy mix over the coming decades. Cooperation and research agreements have thus been signed with France, South Korea and China to advance this effort. In addition, the national oil company Saudi Aramco is developing oil and gas fields in the eastern and northern provinces to secure additional future production. All these projects, whose profitability is ultimately driven by increased oil exports, may potentially be negatively impacted by this risk premium.

   Alternatively, any project turning oil into a product whose price is less correlated with the Saudi economy should benefit from an adjustment quantifying the gain from increased risk diversification (i.e., a negative risk premium). The ongoing move towards downstream chemicals requiring crude-oil-based feedstock may provide examples of such diversifying projects. More generally, the Kingdom is committed to use its oil resources to diversify its economy and reduce its dependence on oil revenues through physical and social investments.

   Quantifying the risk premium will provide a more accurate valuation of all public energy-related projects in the Kingdom. The literature dealing with macroeconomic fluctuations in Saudi Arabia (e.g., Rosser and Sheehan (1995), Dibooglu and Aleisa (2004), Mehrara and Oskoui (2006)) has not addressed this issue. The international literature in general offers very few empirical assessments of risk premia to consider when valuing public investment projects. For instance, Van Ewjik and Tang (2003) discuss the value of risk premia for public projects in the Netherlands; Gollier et al. (2011) discuss this issue in the French context. For the European Union, DurandLasserve et al. (2010) compute a risk premium associated with the [CO.sub.2] price that is consistent with the optimum of their global general equilibrium model. However, to the best of our knowledge, there is no empirical assessment of the risk premium that would be associated with a commodity exported by a resource-rich country. This paper proposes an empirical assessment of the risk premium that could be attributed to crude oil price by Saudi authorities. A significant part of the considerations and methodology presented here could however be transposed to other resource-rich countries, like other OPEC members.

   The next section establishes a simple framework for public investment decision making. Subsection 2.1 examines how past Saudi aggregate consumption and domestic income have been volatile and correlated with crude oil price. In this respect, to become a measure of domestic income, the real GDP has to be adjusted for improvements (or deteriorations) in the Kingdom's terms of trade. We suggest using a command-basis GDP. Subsection 2.2 resumes Gollier's (2007) derivation of the risk premium formula and discusses practical issues for the assessment of this risk premium, as well as related questions on public investment decision-making in the Kingdom. Subsection 2.3 makes some assumptions that will serve to compute the risk premium. Through a simple assessment of the social cost of macroeconomic risks, Section three proposes a first calibration of the short-term (i.e., over a one-year horizon) risk premium associated with oil price. Section four uses two alternative approaches to provide estimates of this risk premium in the long run (i.e., over longer planning horizons): an approach based on a restrictive joint log-normal assumption and another based on cointegration analysis. The last section discusses the implications of these calculations for energy-related public projects in Saudi Arabia and, more generally, for public decision-making in resource-rich countries.

2. A SIMPLE FRAMEWORK FOR PUBLIC INVESTMENT DECISION-MAKING 2.1 Real Oil Price, Saudi Consumption and Domestic Income: A First View

   Figure 1 shows the Kingdom's per-capita Gross Domestic Product (GDP), command-basis GDP, private and gross consumptions, as well as the oil price, all series being expressed in real terms with 1999 as the base year. The data used are provided by Table A6.

   A country's real gross domestic income measures the purchasing power of the total incomes generated by its domestic production. The Saudi real GDP, which is computed by the Saudi authorities at constant 1999 prices, ignores the changes in the relative prices of exports and imports and, therefore, likely underestimates the actual fluctuations in the Kingdom's domestic income. As the world's largest oil exporter, the Kingdom has the nominal value of its exports driven by the volatile crude oil price, while a large portion of its imports consists of manufactured products, which have stickier prices. Over short horizons, the changes in the relative prices of exported oil and imported goods may have a strong impact on the Saudi domestic income; an impact not necessarily reflected in the real GDP. For instance, between 1998 and 1999 a decrease in the volume of Saudi oil exports, along with a simultaneous increase in the nominal price of oil relative to that of imported goods, has led to a decrease in the Saudi real GDP but an increase in the Saudi real domestic income.

   To be interpreted as real domestic income, real GDP has to therefore be adjusted for improvements (or deteriorations) in the Kingdom's terms of trade. We suggest using the Kingdom's command-basis GDP per capita as a measure of the Saudi real domestic income. As discussed by Kohli (2004), instead of deflating nominal imports by the price of imports and nominal exports by the price of exports as in the case of real GDP, the net exports are deflated by the import price deflator. The rationale for this approach is that to quantify real income, what matters is not the quantity of goods and services that are exported, but rather the quantity of imports that is made possible through these exports. The command-basis GDP values used here result from our own (2) calculations. For the sake of simplicity, we adjusted the real GDP by considering that all exports were oil-related, since non-oil exports represent only a small fraction of Saudi exports (12.7% on average between 2007 and 2010); half of them being made of petrochemical products whose prices are reasonably well-correlated with oil price. Since the geographical origin of the Saudi imports is relatively well-diversified, with a large share of consumer goods, the World Bank's world consumer price index (world CPI) is used as a proxy for the import price deflator. The adjustment for year t is therefore the difference between the nominal exports deflated by the world CPI and the product of the nominal exports by the ratio of the oil price in 1999 over the nominal oil price in year t.

   In this paper, the real price of crude oil, given (3) in 1999 USD per barrel, is defined as the nominal price of the Arabian Light deflated by the World Bank's world CPI. The gross consumption is the sum of private and government consumptions. The government consumption, whose share in the Kingdom's economy is relatively important, includes non-durable public goods. In this paper, the gross consumption is therefore considered as a relevant indicator for consumption. Data in real terms are only available from 1998 to 2010. Since during...