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Vulnerability of the EU Economy to Oil Shocks: a General Equilibrium Analysis with the GEM-E3 Model

Juan Carlos Ciscar*, Peter Russ*, Leonidas Parousos **, and Nikos Stroblos** * Institute for Prospective Technological Studies (IPTS)1 ** National Technical University of Athens (NTUA)

Abstract This article presents a comparative statics analysis of the potential impact of oil price rises on the EU economy. The macroeconomic and sectoral effects of such oil shocks are quantitatively assessed for two basic scenarios with the GEM-E3 world model. The first scenario assumes a crisis leading to an increase of 10$ per barrel of oil. The second one consists of a much deeper energy crisis, and translates into a rise of 30$ per barrel of oil. The crude petroleum, petroleum refineries and energy-intensive sectors undergo a significant fall in their value-added. Almost 40% of the overall GDP fall comes from the Other market service sector, while the Trade and Transport sector and the Other equipment goods sector represent each approximately 10% of the overall GDP fall. The GDP losses for the EU as a whole are 0.94% in the first scenario and 2.56% in the second. The macroeconomic impact is slightly lower in the USA (0.81% and 2.21%, respectively). Australia, the FSU, India and Japan have very similar losses to that of the whole EU, while China and Africa experience a bigger GDP drop. The world GDP loss figures are very similar to those of the EU.

(*) We would like to thank especially Nikos Kouvaritakis (NTUA) for his fruitful comments and suggestions. We would also to thank the IPTS colleagues Andries Brandsma, Luis Delgado, Ignacio Hidalgo, Antonio Soria, and Per Srup, as well as Cristobal Burgos from DG TREN, for their comments.

Directorate-General Joint Research Center. Opinions expressed in this article do not necessarily reflect those of Institute, Directorate-General or the European Commission.

Table of Contents

1 2

INTRODUCTION.........................................................................................................................3 REVIEW OF PAST OIL-SHOCK EXPERIENCES .................................................................4 2.1 2.2 2.3 2.4 2.5 OIL PRODUCTION DISRUPTIONS AND OIL PRICES .....................................................................4 MACROECONOMIC EFFECTS OF PAST SHOCKS ON THE EU ECONOMY .....................................5 GDP LOSS DUE TO MORE EXPENSIVE OIL IMPORTS .................................................................7 STATISTICAL AND ECONOMETRIC ESTIMATES OF THE OIL PRICE-GDP RELATIONSHIP ............7 MODEL-BASED ESTIMATES OF THE MACRO EFFECTS OF OIL CRISES ........................................8

METHODOLOGY .......................................................................................................................9 3.1 3.2 3.3 THE GEM-E3 MODEL ............................................................................................................9 DEFINITION OF SCENARIOS ....................................................................................................9 INTERPRETATION, CAVEATS AND LIMITATIONS OF THE METHODOLOGY .............................10

RESULTS ....................................................................................................................................12 4.1 4.2 4.3 4.4 MACROECONOMIC EFFECTS IN THE EU AS A WHOLE ............................................................12 MACROECONOMIC EFFECTS IN THE EU REGIONS ..................................................................13 SECTORAL EFFECTS IN THE EU AND EU REGIONS ................................................................15 WORLD REGION RESULTS .....................................................................................................19

CONCLUSIONS .........................................................................................................................20

REFERENCES .....................................................................................................................................21 ANNEX 1. REGIONAL COVERAGE OF THE GEM-E3 MODEL...............................................23 ANNEX 2. SECTORAL COVERAGE OF THE GEM-E3 MODEL...............................................24 ANNEX 3. IMPLEMENTATION OF THE OIL PRICE SHOCKS IN THE MODEL .................29

Introduction

Nowadays approximately half of the EU energy needs are imported. The dependence on external sources of energy supply is expected to rise considerably in the coming decades, to around 70% in 2030 (European Commission, 2001). This entails a significant potential vulnerability of the EU economy to eventual oil price rises. For instance, geopolitical instability in the Middle East can alter the world oil market, which in turn would significantly affect the EU, as already occurred in the 1970s oil shocks2. This article addresses the economic consequences on the EU associated to an oil price crisis and, in particular, quantitatively assesses the potential macroeconomic and sectoral effects of two oil shock scenarios on the EU economy3. An increase in oil prices leads both to a real loss of income in the EU and, through changes in relative prices, to a significant reallocation of resources within the goods, services, capital and labour markets. In order to analyse such macroeconomic impacts the world General Equilibrium Model for Energy-Economy-Environment interactions (GEM-E34) has been applied. GEM-E3 is a computable general equilibrium model of the world economy able to quantify those impacts by using the relevant contributions from economic theory and adequate statistical data bases (based mainly on social account matrixes). The model computes the equilibrium prices of goods, services, labour and capital that simultaneously clear all markets in the world regions.

The Focus section of the Quarterly Report on the Euro Area (European Commission, 2003a) studied the economic consequences of the Iraqi conflict on the economy of the euro area. Similar studies have studied the consequences on the US economy (see Nordhaus (2003) and Perry (2001)). For the analysis of the macroeconomic effects of higher oil prices see for instance Hudson and Jorgenson (1978) and Hunt et al. (2001). The design of the scenarios of this exercise has been made jointly by DG TREN C1 and IPTS/JRC. The model scenarios have been implemented and run by NTUA. The GEM-E3 model was constructed by a collaborative project team, partially financed by the JOULE Programme of the European Commission (DG RTD), and involved NTUA as a co-ordinator, KUL/CES, University of Toulouse, University of Mannheim, University of Strathclyde and CORE. The model has been widely used in studies for the European Commission, including The Review of the Single Market, The Double-Dividend Analysis, The Evaluation of Energy Taxation, The MacroEconomic Costs for the EU of reaching the Kyoto targets, and others. The model has been successfully peer reviewed by the European Commission in 1998.
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This article has four sections, in addition to this introduction. In the first section the past oil shock experiences are reviewed. Section two presents the methodology followed in this article. Section three analyses the main results. Section four concludes. 2 Review of past oil-shock experiences

The evolution of oil prices for the period 1970-2001 is shown in Figure 1 both in current and constant (1999 $) terms. The two oil shocks of the 1970s, 1973-1974 and 1979-1980, can be clearly identified. Real oil prices quadrupled during the first shock and tripled during the second shock. Figure 1. 1970-2001 Oil prices per barrel

80 70 60 50 40 30 20 10 0 1970 C u rre n t $ 1999 $

1975

1980

1985

1990

1995

2000

Source: BP 2.1 Oil production disruptions and oil prices

The major cause explaining the 1970s oil crises are exogenous disruptions in world petroleum supply. According to the computations of Hamilton (2003) the drop in world production in the 1973 Arab-Israel war could be estimated to be 7.8%, and 8.9% in the 1978 Iranian revolution.

The OPEC cartel controls a large part of the world oil production and most of the proven reserves5. The behaviour of the OPEC countries, and in particular its degree of coordination in supplying the world oil market, plays a significant role in the determination of the world oil prices. The oil market is difficult to model due to its non-competitive nature. When OPEC countries have succeeded in controlling their supply provided to the world oil market, the cartel has been able to significantly influence prices. 2.2 Macroeconomic effects of past shocks on the EU economy

The effects of 1970s oil price shocks on economic growth have been substantial. In general terms, they provoked slower economic growth, higher unemployment, a process of employment destruction and higher inflation rates. Table 1 and Figure 2 present the case of the 1979 shock. As it can be seen, the rise in oil prices that took place during 1979 was followed by very low economic growth rates in the 1980-1982 period. Table 1. The 1979 Oil shock impact on EU growth

GDP growth oil price (%) (1999 $) 1978 3 34.9 1979 3.5 69.2 1980 1.3 72.4 1981 0.1 63.0 1982 1 55.0 1983 1.9 48.2 1984 2.5 45.1 1985 2.5 42.7 Source: Eurostat, BP

According to BP data (BP, 2003), in 2001 OPEC countries supplied 40.7% of world oil production and accounted for 78% of the proven reserves. 65.3% of the proven reserves are in the Middle East.

Figure 2. The 1979 Oil shock impact on EU growth


4.0 3.5 GDP growth (%) 3.0 2.5 2.0 1.5 1.0 0.5 0.0 1978 1979 1980 1981 1982 1983 1984 1985 GDP growth (%) oil price (1999 $) 80 70 60 50 40 30 20 10 0 oil price (1999 $)
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Figure 3 plots the EU economic growth rates against the real price of oil in the 19762001 period. Considerable research work has been done to quantify the apparent negative relationship between oil price and economic growth. Some of this research will be summarised below. Figure 3. EU-15 real growth and real price of oil 1976-2001
80 70 Real price of Oil (1999$) 60 50 40 30 20 10 0 -1 0 1 2 3 4 GDP Real Growth (%)

However, before reviewing the empirical evidence on the effects of oil price shocks on the economy, it is interesting to recall the actual dependence of the EU on oil imports. Table 2 gives the gross inland consumption of oil in the EU and compares it with the net oil imports for the period from 1985 to 1999. The rate of oil dependence 6

has remained relatively high (above 75%) for the whole period, pointing out the vulnerability of the EU economy to hypothetical future oil shocks in the future6. Table 2. The Oil Dependence of the EU Economy
Oil Consumption Oil Net Imports Oil dependence (%) 1985 511 382 75% 1990 546 460 84% 1991 563 476 85% 1992 571 482 84% 1993 565 467 83% 1994 568 446 79% 1995 576 446 78% 1996 588 465 79% 1997 588 470 80% 1998 601 490 81% 1999 595 458 77%

Note: Gross Consumption and Net oil imports in 1000s ktoe Source: Eurostat 2.3 GDP loss due to more expensive oil imports

One immediate effect of higher oil prices is more expensive oil imports, which given the share of oil net imports in the EU economy, leads to a fall in GDP. According to Eurostat in 2001 EU net imports of petroleum and petroleum products amounted to 87.7 billion Euro, 0.99% of GDP. The average price of the Brent oil was 24.77 dollars. An increase of 10 dollars in the price of oil would lead, keeping constant the volume of oil imports, to a fall of 0.40% of GDP, and a 30 dollars increase would reduce GDP by 1.20%. These estimates do not take into account other fundamental effects of oil price shocks that further affect GDP (e.g. the fall in GDP due to more expensive imports depress consumer spending, triggering chain effects on the overall economy, in addition to the effects on demand because of uncertainty) and, therefore, are to be interpreted as underestimates of the actual impact of an oil price shock on GDP. 2.4 Statistical and econometric estimates of the oil price-GDP relationship

The relationship between oil price and GDP appears to have been relatively linear after World War II to the late 1970s7. This would imply that either a positive or a negative oil shock would affect economic activity by the same magnitude. However, with the drop in oil prices in the 1980s GDP did not rise as the noted linear relationship would imply. Therefore, a series of econometric studies has intended to restore the stability of the relationship between oil prices and GDP through non-linear

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See the EU green paper on security of energy supply (European Commission, 2001). In mathematical terms the log of real GDP is linearly related to the log of the real price of oil

specifications, leading notably to asymmetric responses of GDP to oil price changes8. These studies conclude that increases in oil price affect GDP more than drops in oil prices9. Concerning the magnitude of the oil price-GDP relationship Jones et al. (2002) conclude that the oil price-GDP elasticity for the US economy is around -0.055, this being this the cumulative effect on GDP over a 2-year period of a shock in one period only, regardless whether the price increase is sustained10. 2.5 Model-based estimates of the macro effects of oil crises

The transmission mechanisms through which an oil shock affects GDP are made explicit in economic models. There are two major channels. First, an increase in the oil price alters the supply of the economy because of the raise in energy costs, which provokes a supply-driven recession. Second, an oil shock also affects the demand-side of the economy due to the effect of lower income on consumer and business behaviour. Furthermore, there is an additional demand-side effect because consumer spending and investment decisions are postponed due to the uncertainty about the future oil prices11. The fall in the consumption and investment components of aggregate demand therefore provokes a recession in the economy. The accuracy of the estimated impacts depends of course on the model characteristics12. The better the transmission channels of the oil shock are modelled, the more reliable are at first the quantitative estimates.

8 9

See e.g. Hooker (1997) and Hamilton (2003).

Hamilton (2003) notes that there is evidence suggesting that oil shocks are important because they disrupt spending by consumers and firms on certain key sectors of the economy.
10

It could be argued, applying the arc elasticity concept, that this value of the elasticity implies that a 50% increase in the price of oil would lead to a fall in GDP of 2.75%. Doubling the oil price would lead to a 5.5% loss of GDP. The irreversible investment model, stating that uncertainty situations lead to postponement of investment decisions because of the intrinsic irreversibility nature of the investment decisions, is of particular significance in this respect. See the interesting discussion on this issue in section 5 of Jones et al. (2002), which deals with the IMFs MULTIMOD and the OECDs INTERLINK models.

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3 3.1

Methodology The GEM-E3 Model

GEM-E3 World model is a multi-region applied general equilibrium model of the world economy providing detailed results on macroeconomic variables, sectoral activity, trade and their interaction with the environment13. It is an empirical, largescale model, calibrated to a base year14 using the Global Trade Analysis Project (GTAP) v.4 database. The model is not stochastic15. The model aggregates the national economies of the world into twenty-one regions, among which four EU regions, and links them through endogenous trade of goods and services. GEM-E3 includes twenty sectors and various economic agents, for which it formulates their individual economic behaviour and their interactions as demanders and suppliers of goods and services. The model covers the major aspects of public finance, including all substantial taxes, social policy subsidies, public expenditures and deficit financing. One feature of the modelling approach consists of the absence of involuntary unemployment by definition. At the market real wage labour supply equals labour demand. The model determines the equilibrium prices and quantities that simultaneously clear all markets, taking into account the optimising behaviour of economic agents. The results of GEM-E3 include detailed input-output tables by region, national accounts, employment, balance of payments, public finance, household consumption, and energy use and supply, among other endogenous variables. The computation of the equilibrium is simultaneous for all domestic markets and their interaction through flexible bilateral trade flows. 3.2 Definition of Scenarios

The model application implemented compares two cases: Baseline case: basically capturing the current state of the economy.

13 14 15

See Capros et al. (1997). The base year of the current version of the model is 1995.

Sensitivity analyses in order to assess the robustness of some outputs are of course possible. Applying Monte-Carlo techniques for this purpose, however, is almost impossible due to the model size.

An alternative case with an increase in the oil price due to geopolitical instability in the Middle East region. Two scenarios of interest have been studied16. Scenario 1. The crisis leads to a rise of 10$ per barrel in the world oil price. Scenario 2. Under this scenario there is a sharp rise of oil price. This increase is assumed to be 30$ per barrel.

This is a typical exercise of comparative statics. The differences between the baseline and the alternative case are the consequences of the oil price change. In particular, the higher oil prices implied by the alternative scenarios impose an additional cost to the economy, therefore modifying the optimal choices of the economic agents. The resulting prices and quantities characterise the new equilibrium, in which supply equals demand in all markets, once all adjustments have occurred17. This equilibrium approach allows taking into consideration not only the direct effect of an oil shock, but also the indirect and feedback effects between markets (multi-sectoral approach). The model is explicitly considering the substitution possibilities of the economy as a whole, e.g., the substitution of oil (an input relatively more expensive after the oil shock) for gas and coal and, on a more aggregate level, the substitution of energy (a comparatively more expensive production factor) by other factors, i.e. labour and capital. The causes behind the oil price increases are not addressed in this paper. An oil price rise could be motivated by a real oil supply shortage (induced, for instance, by a geopolitical crisis) or by an expected oil supply shortage, when agents discount or anticipate a possible but not yet accomplished oil shock18. 3.3 Interpretation, Caveats and Limitations of the Methodology

Before discussing the output of the model runs, it is important to remark the following points:

16 17

Annex 3details the implementation of the oil shocks in the model.

The time path of the adjustment to the oil price shock is not modelled explicitly. Information from dynamic models would be needed to give an indication of that adjustment path over time. Assumptions could be made concerning the responses of economic agents (including the government, for instance on compensation for the rise in oil prices) that would indeed affect the impact of the shock on the different macroeconomic variables.
18

The oil price outburst of January-March 2003 would follow this pattern. International oil markets anticipated for a relatively long period the possibility of an oil shortage due to the crisis in the Gulf.

10

It is important to take into account the essence of the general equilibrium approach in what concerns the interpretation of the results. The results in the alternative scenarios are always interpreted in relative terms, as changes or differences with regard to the baseline scenario.

The model is formulated and solved in real terms. Monetary and financial issues are not considered. The results of the model runs are not predictions or forecasts. The model gives insights on the order of magnitude and sign of the evolution of economic variables if there were an oil shock and if the economy adjusted completely to the new oil prices. The equilibrium paradigma in economic theory is being assumed.

In the model runs the oil shock affects the economy through its effect on the oil price (substitution and income effects), but in addition there are other transmission mechanisms, such as the effects due to the increased uncertainty faced by economic agents (decision to postpone investment and consumption decisions, rise in risk premium in financial assets, etc), not considered explicitly in the model19.

It should be noted that the applied model assumes full market flexibility and optimal behaviour of economic agents. Yet the experience of the previous oil shocks indicates that because of market imperfections and rigidities (particularly in labour markets) the actual macroeconomic impacts may be higher than those given here, due to this non-addressed inefficiency costs.

The results to can be interpreted in time-proportional terms in the following sense. The shock takes place in a certain year and the measured results all are defined in annual terms. Therefore it could be interpreted that if the actual price increase in oil prices is for instance half the size of the assumed in scenario 1, the effect on GDP would be half the estimated one20.

No changes of economic policy in response to the oil shock have been assumed.

19

The worse case scenario of the 2003 Spring Economic Forecast (European Commission, 2003b) would lead to a fall of GDP of almost 1% in the euro area according to the QUEST model, of which approximately 30% could be attributed to the rise in oil prices and the rest to the fall in confidence, the rise in the risk premium and financial stress. This proportionality principle can be applied because the production functions are constant-elasticity of substitution (CES ) type and log-linear.

20

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4 4.1

Results Macroeconomic effects in the EU as a whole

The macroeconomic effects of the two scenarios, as compared to the baseline or reference case are shown in Table 3. In scenario 1 GDP in the EU falls by 0.94%21. This reflects the impoverishment effect caused by the energy shock. A basic production factor, oil, has become more expensive and this provokes a GDP loss because the level of production of the baseline case cannot be attained. Indeed, the fall in GDP has its main origin in the diminution of the productivity of the production factors in the economy. From the aggregate demand perspective, the GDP loss is mainly caused by a fall in private consumption (which diminishes by 1.39%), the main component of GDP. The consumption possibilities of households decrease, due to the fall in real wages. Regarding the trade flows, exports diminish mainly because of the global economic slowdown (world GDP falls by 0.93% and by 2.54% in scenarios 1 and 2, respectively). Imports also diminish due to the lower GDP level. Since labour becomes relatively cheaper than oil as a production factor, under the new equilibrium the employment level is slightly higher than in the baseline case. Table 3. Macroeconomic Effects on the EU
Scenario 1 Scenario 2

GDP Private Investment Private Consumption Exports in volume Imports in volume Employment

-0.94% -0.16% -1.39% -0.83% -0.59% 0.03%

-2.56% -0.45% -3.83% -2.14% -1.63% 0.08%

With respect to scenario 2, the sign of the effects is the same but the intensity much higher. In this case, GDP falls in the EU by 2.56%, and private consumption by 3.83%. This GDP loss is close to the long-term annual economic growth (in the range of 2 to 3%)22.

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This represents approximately 84.6 billion Euro, in current terms.

EU real average economic growth in the 1961-2002 period has been 2.98%, and during the 19902002 period 2.03%.

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4.2

Macroeconomic effects in the EU regions

Table 4 presents the macroeconomic effects for the four EU regions of the model: Germany (D), UK, NEU region (composed of Denmark, Sweden and Finland) and the rest of EU countries (OEU region). The UK region seems to be the one relatively least affected by the energy shock, which could be explained by its oil resources, while Germany (D) and the other EU countries (OEU) region are the most affected. Table 4. Macroeconomic Effects on the EU Regions
Scenario 1
OEU D UK NEU OEU

Scenario 2
D UK NEU

GDP Private Investment Private Consumption Exports in volume Imports in volume Employment

-1.00% -0.21% -1.57% -0.50% -0.70% 0.03%

-0.91% -0.09% -1.06% -1.34% -0.31% 0.00%

-0.83% -0.15% -1.34% -0.57% -0.70% 0.05%

-0.88% -0.17% -1.25% -0.91% -0.43% 0.02%

-2.72% -0.59% -4.38% -1.11% -1.96% 0.10%

-2.47% -0.24% -2.91% -3.57% -0.83% 0.00%

-2.27% -0.39% -3.64% -1.59% -1.87% 0.11%

-2.39% -0.47% -3.44% -2.43% -1.17% 0.06%

Note: NEU= DK, S, FIN; OEU= other EU countries The impact of the oil shock on GDP can be decomposed into the various aggregate demand components of GDP, by using the following standard national accounts identity: GDP= Consumption + Investment+ Public expenditure + Exports Imports Table 5 presents the results of such decomposition.

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Table 5. Shares of GDP losses by Demand Component Scenario 1 Private Consumption Private Investment Public Expenditure Exports in volume Imports in volume GDP Scenario 2 Private Consumption Private Investment Public Expenditure Exports in volume Imports in volume GDP
OEU D UK NEU EU total

108 4 0 11 -24 100


OEU

62 2 0 44 -8 100
D

100 3 0 22 -24 100


UK

68 3 0 42 -13 100
NEU

91 3 0 24 -18 100
EU total

111 5 0 9 -25 100

63 2 0 43 -8 100

99 3 0 22 -23 100

69 3 0 41 -13 100

92 3 0 23 -19 100

Note: NEU= DK, S, FIN; OEU= other EU countries In the OEU and UK regions most of the GDP fall is explained by the behaviour private consumption23. Moreover, the fall in imports approximately mitigate a quarter of the overall GDP contraction. With regard to the D and NEU regions, the contribution of private consumption is lower than in the OEU and UK regions. For the EU as a whole the contribution of the fall in exports to the overall GDP fall is around 25%. When the fall in imports is taken into account, the contribution of external trade is negative in both scenarios, explaining around 5% of the GDP fall. This is indeed reflecting the competitiveness loss of the EU due to the oil price rise. With regard to the contribution of public expenditure it is zero, by definition since it is assumed that public expenditure policy does not change after the shock, and remains the same across all cases and scenarios.

23

The role played by the model disaggregation of the EU into four regions should be taken into account. In particular, the intra-EU trade is visible in the form of export and import flows for the single-country regions of the model (Germany and UK) and to a lesser extend in the NEU and REU regions (composed of three and ten countries respectively)"

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4.3

Sectoral effects in the EU and EU regions

The sectoral24 effects of the oil shock are given in Table 6. The oil price shock is at a first stage affecting mainly the oil-related sectors, but due to the interlinkages between the economic sectors, the shock in transmitted to the rest of the economy through a series of market adjustments. The results presented below give the situation once those adjustments have taken place in the new equilibrium. The change in valueadded of each sector, compared to the baseline, is in fact offering an interesting perspective of the major sectoral adjustment processes taking place in the economy. In general terms, both supply (firm decisions) and demand (household decisions) factors lead to a relative shift in the sectoral value-added of the economy towards less oil-intensive sectors. Table 6. Sectoral Effects in the EU (change in value-added)
Scenario 1 Scenario 2 -1.16% -3.10% 0.20% 0.58% -1.87% -6.50% 0.36% 0.83% -0.84% -2.29% -1.93% -5.19% -1.05% -2.85% -0.68% -1.81% -0.97% -2.59% -1.32% -3.56% -1.48% -3.93% -2.26% -6.13% -0.86% -2.34% -2.10% -5.62% -0.52% -1.41% -1.21% -3.23% -1.17% -3.19% -0.30% -0.82% -3.42% -8.15% 0.12% 0.29%

01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20

Agriculture Coal Petroleum Refineries Distribution of Gasseous Fuels - Manufacture of Gas Electricity Ferrous and non ferrous metals Chemical Products Other energy intensive Electronic Equipment Transport equipment Other Equipment Goods Other Manufacturing products Construction Food Industry Trade and Transport Textile Industry Other Market Services Non Market Services Crude Petroleum Natural Gas Production

Table 7 gives the change of unit costs of production per sector and EU region in the

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The definition and sub-sectoral coverage of the 20 sectors of the GEM-E3 model is provided in Annex 2.

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two scenarios, relative to the baseline. Unit costs increase in all sectors, showing the productivity fall in the production factors of the economy, induced by the oil price shock. In both scenarios the highest increases in unit costs are located in the oilrelated sectors. In scenario 1 Crude petroleum unit costs rise by 30%, and Petroleum refineries costs rise by 13%. Those higher unit costs, as well as the relative change in costs vis--vis other primary fuels, lead to a significant drop in the economic activity of the two oil-related sectors, as can be seen in Table 6. The coal and gas sectors (number 2, 4 and 20) on the contrary see an improvement in their value-added in both scenarios, due mainly to the substitution effect among the primary fuels. As can be seen in Table 7 their unit costs rise quite less than those of oil products. With regard to the industrial sectors, those with higher oil-intensity experience a higher relative drop in value-added. The Ferrous and non ferrous metals sector, Other manufacturing products and the Food industry are those most relatively affected by the oil shock. The Construction sector (with low exposition to external competition) experiences a relative contraction slightly below that of GDP. The Nonmarket services sector (composed mainly by the public sector services e.g. health and education) is relatively little affected by the shock and, indeed, its unit costs rise by the lowest rate. The Other market services sector value-added drops more than total GDP. Indeed, almost 40% of the overall GDP fall comes from this sector, while the Trade and Transport sector and the Other equipment goods sector represent each approximately 10% of the overall GDP fall. In this respect, it might be of interest to give a closer look at the shares of each sector in the GDP loss provoked by the oil shock. Table 825 represents the sectoral shares of GDP in the base year (baseline) and the shares of GDP losses in the two scenarios for the four EU regions of the model, as well as for the EU as a whole. The following results for the whole EU can be remarked:

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Note that in Table 8 zero numbers do not mean necessarily imply zero share, because of the rounding effect.

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Table 7. Change in Unit costs of production per sector and EU region


Scenario 1
OEU D UK NEU OEU

Scenario 2
D UK NEU

01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20

Agriculture. Coal. Petroleum Refineries. Distribution of Gasseous Fuels - Manufacture of Gas. Electricity. Ferrous and non ferrous metals. Chemical Products. Other energy intensive. Electronic Equipment. Transport equipment. Other Equipment Goods. Other Manufacturing products. Construction. Food Industry. Trade and Transport. Textile Industry. Other Market Services. Non Market Services. Crude Petroleum. Natural Gas Production.

1.7% 1.9% 13.6% 3.0% 1.5% 1.9% 1.6% 1.4% 1.3% 1.5% 1.3% 1.3% 1.2% 1.5% 1.2% 1.4% 1.0% 0.9% 30.3% 2.4%

1.5% 1.6% 16.5% 2.2% 1.7% 2.3% 2.0% 1.8% 1.7% 1.9% 1.8% 1.8% 1.7% 1.8% 1.6% 1.7% 1.6% 1.6% 30.3% 5.3%

1.1% 0.8% 17.9% 7.3% 2.3% 1.6% 2.0% 1.3% 1.3% 1.5% 1.4% 1.3% 1.3% 1.3% 1.3% 1.2% 1.1% 0.7% 30.3% 3.1%

1.3% 1.4% 13.9% 3.2% 1.8% 2.1% 1.8% 1.6% 1.4% 1.6% 1.6% 1.5% 1.6% 1.6% 1.5% 1.4% 1.3% 1.2% 30.3% 4.7%

4.5% 5.3% 40.2% 8.6% 4.1% 5.2% 4.4% 3.7% 3.4% 4.0% 3.4% 3.5% 3.2% 4.1% 3.1% 3.7% 2.5% 2.2% 90.9% 6.6%

4.0% 4.4% 49.2% 6.2% 4.5% 6.4% 5.6% 4.9% 4.5% 5.1% 4.8% 4.8% 4.7% 4.9% 4.4% 4.7% 4.3% 4.4% 90.9% 15.5%

3.0% 2.1% 53.5% 21.7% 6.6% 4.5% 5.5% 3.5% 3.6% 4.0% 3.8% 3.6% 3.7% 3.6% 3.5% 3.2% 2.9% 1.8% 90.9% 9.2%

3.5% 3.8% 41.3% 9.0% 4.9% 5.8% 4.9% 4.5% 3.9% 4.3% 4.3% 4.0% 4.4% 4.2% 4.1% 3.6% 3.5% 3.3% 90.9% 13.7%

Note: NEU= DK, S, FIN; OEU= other EU countries

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Table 8. Sectoral Shares of GDP losses in the four EU regions and the EU
SHARES of GDP BASELINE
OEU D 2.4 0.4 0.2 0.6 1.2 1.4 4.0 3.1 0.7 4.1 9.4 2.4 5.8 3.4 18.7 1.4 22.7 18.1 0.0 0.1 UK 2.0 0.2 0.5 0.6 0.7 1.1 3.3 3.4 1.4 1.8 5.2 1.2 5.3 3.3 23.3 1.5 24.1 19.4 1.0 0.6 NEU EU total NEU 5.0 0.0 0.6 0.3 2.8 1.2 3.2 5.9 2.0 2.4 6.3 2.2 6.2 3.8 24.6 1.1 21.8 10.1 0.2 0.2 2.0 0.1 0.4 0.4 1.3 1.0 3.6 3.1 1.4 2.8 6.4 2.1 6.0 2.9 18.5 1.6 30.2 15.9 0.2 0.2 100.0 2.8 0.1 0.7 0.0 1.2 1.6 3.4 1.7 1.7 2.7 5.8 4.6 6.0 6.2 7.8 2.3 47.3 4.0 0.1 0.0 D 2.0 -0.1 0.7 -0.5 1.0 3.1 5.4 2.8 1.0 6.9 17.8 5.5 3.4 6.8 10.7 2.1 23.5 7.9 0.1 -0.1

SHARES of GDP LOSS Scenario 1 Scenario 2


UK 1.8 -0.2 0.7 0.1 0.9 1.4 3.8 1.8 1.2 1.7 8.0 4.6 9.4 6.7 16.0 1.3 33.3 3.5 4.0 0.0 OEU EU total NEU 3.5 0.0 1.0 -0.3 2.2 2.3 2.8 5.3 1.9 2.7 9.5 5.3 3.6 7.6 15.4 1.0 32.2 3.3 1.0 -0.2 2.5 0.0 0.7 -0.2 1.2 2.1 4.0 2.2 1.4 3.9 10.0 4.9 5.5 6.5 10.2 2.0 37.4 5.1 0.7 0.0 100.0 2.7 0.1 1.0 0.0 1.2 1.6 3.3 1.6 1.7 2.7 5.6 4.6 6.0 6.1 7.8 2.2 47.8 4.0 0.1 0.0 D 2.0 -0.1 0.7 -0.5 1.0 3.1 5.4 2.7 1.0 6.9 17.6 5.6 3.5 6.8 10.7 2.1 23.6 7.9 0.1 -0.1 UK 1.8 -0.2 1.0 0.2 0.9 1.4 3.9 1.8 1.3 1.8 8.1 4.5 9.3 6.6 16.0 1.3 33.1 3.5 3.5 0.0 OEU EU total 3.5 0.0 1.3 -0.3 2.2 2.3 2.8 5.2 1.9 2.7 9.4 5.3 3.6 7.5 15.4 1.0 32.3 3.3 0.8 -0.1 2.4 0.0 0.9 -0.1 1.2 2.0 4.0 2.2 1.4 3.8 9.8 4.9 5.5 6.4 10.2 2.0 37.7 5.1 0.6 0.0 100.0

01 Agriculture. 02 Coal. 03 Petroleum Refineries. 04 Distribution of Gasseous Fuels - Manufacture of Gas. 05 Electricity. 06 Ferrous and non ferrous metals. 07 Chemical Products. 08 Other energy intensive. 09 Electronic Equipment. 10 Transport equipment. 11 Other Equipment Goods. 12 Other Manufacturing products. 13 Construction. 14 Food Industry. 15 Trade and Transport. 16 Textile Industry. 17 Other Market Services. 18 Non Market Services. 19 Crude Petroleum. 20 Natural Gas Production. Total

1.3 0.0 0.4 0.2 1.3 0.7 3.5 2.6 1.8 2.2 4.7 2.1 6.4 2.4 16.1 1.8 38.1 14.3 0.0 0.2

100.0 100.0 100.0 100.0

100.0 100.0 100.0 100.0

100.0 100.0 100.0 100.0

Note: NEU= DK, S, FIN; OEU= other EU countries

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The oil shock seems to affect significantly the demand for private services, and proportionally to their share in GDP. Indeed, almost half (47% to 48%) of the overall fall in GDP in both scenarios is located in the Other market services and Trade and transport sectors, a very similar figure to their joint participation in GDP (48.7%). With regard to the Other market services sector, while it represents 30.2% of GDP in the base year, it is the sector absorbing the highest share of the GDP loss, approximately 37.5% in both scenarios. On the contrary, the Trade and transport sector is relatively less affected by the oil shock: representing 18.5% of GDP in the baseline, it absorbs 10.2% of the GDP fall. This might be due to the composition of this sector. While the demand for transport services component is much affected by the oil price shock, the trade component is relatively less sensitive to such shock.

The third sector in importance according to the share in the overall GDP fall is the Other equipment goods sector. While it accounts for 6% of GDP in the baseline, it represents around 10% of the GDP loss in both scenarios. The equipment goods might be longer used, and therefore later replaced, in a context with higher energy prices.

Energy-intensive sectors (the Ferrous and non ferrous metals, Chemical products and Other energy intensive sectors), which account all together for 7.7% of GDP in the baseline, absorb 8.2% of overall impact in GDP. The Ferrous and non ferrous metals sector is the one that undergoes the highest relative impact. While it represents 1% of GDP, it absorbs 2% of the GDP fall. This is explained by the evolution of its unit costs of production, which rise at the highest rate among the industrial and service sectors.

The primary energy and transformation sectors (Coal, Petroleum refineries, Distribution of gaseous fuels and manufacture of gas, Crude petroleum and Natural gas production) account for very little of the overall GDP fall (in the range of 1.2 to 1.4%), and have a very similar share in GDP (1.3%). The Distribution of gaseous fuels and manufacture of gas sector is the only sector in the economy enjoying an improvement. Its production increases, contributing positively to the GDP of the economy by 0.2% and 0.1 % of the overall GDP fall in scenarios 1 and 2, respectively.

4.4

World region results

The GEM-E3 world model provides with macro and sectoral results, of the same kind as those seen in the previous subsections, for the seventeen non-EU regions. For brevity, Table 9 reports the results on the GDP for some world regions and on the world 19

economy26. Compared to the impact on the EU as a whole, for scenario 1 the USA (with a significant domestic oil production) has a lower GDP loss (of 0.81%, compared to a 0.94% in the EU). The same happens for scenario 2. Australia, India and Japan have very similar losses to that of the whole EU, while China and Africa (very vulnerable because of their lack of domestic oil resources and, for the case of China its fast economic growth) experience a much bigger GDP drop. The world GDP loss figures are very similar to those of the EU. Table 9. Effects on GDP of World Regions
Scenario 1 Australia and New-Zealand Japan China and Hong Kong India South Asia South-East Asia USA Canada Mexico and Brazil Latin America Nordic EU (NEU) Germany UK Other EU (OEU) Other European countries Central Europe Africa Rest of the World WORLD
-0.90% -0.88% -1.35% -0.90% -0.97% -1.05% -0.81% -0.84% -0.94% -0.91% -0.88% -0.91% -0.83% -1.00% -0.86% -1.06% -1.11% -0.77%

Scenario 2
-2.53% -2.38% -3.75% -2.53% -2.72% -2.93% -2.21% -2.32% -2.62% -2.56% -2.39% -2.47% -2.27% -2.72% -2.38% -2.91% -3.30% -2.11%

-0.93%

-2.54%

Conclusions

Oil imports in the EU account for approximately 1% of GDP. However, in spite of such low figure, oil price increases produce a major effect on economic growth, due to the essential role played by oil in the economy. Indeed, around 75% of oil consumption is imported from abroad, which makes the EU particularly vulnerable to possible energy crises.

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See Annex 1 for the country coverage of each region of the model.

20

An analysis of the potential impact of oil price rises on the EU economy has been conducted applying the GEM-E3 world model. Two scenarios have been considered. The first scenario assumes an increase of 10$ per barrel of oil. The second one consists of a much deeper energy crisis, and translates into a rise of 30$ per barrel of oil. The GDP losses for the EU as a whole are 0.94% in the first scenario and 2.56% in the second. The macroeconomic impact of the oil shocks is slightly lower in the USA (0.81% and 2.21% for the two scenarios, respectively). Emerging economies, such as China, seem to be relatively more vulnerable to the shock than advanced OECD economies. References BP (2003). BP statistical review of world energy 2002. Downloaded from http://www.bp.com/centres/energy2002/index.asp Capros P. et al. (1997). The GEM-E3 model: Reference Manual. The GEM-E3 Model for the European Union. National Technical University of Athens. Available at http://www.e3mlab.ntua.gr European Commission (2001). Green Paper: Towards a European strategy for the security of energy supply. Directorate-General Energy and Transport. Available at http://europa.eu.int/comm/energy_transport/en/lpi_lv_en1.html European Commission (2003a). Quarterly Report on the Euro Area, No. I/2003. Directorate-General for Economic and Financial Affairs. European Commission (2003b). Spring 2003 Economic Forecasts. Directorate-General for Economic and Financial Affairs. To be published as European Economy n 2/2003. Hamilton, D (2003). What Is an Oil Shock? Journal of Econometrics, vol. 113, pp. 363398. Hooker, M. S. (1997). Exploring the Robustness of the Oil Price-Macroeconomy Relationship. Finance and Economic Discussion Series 1997-56. The Federal Reserve Board. Available at http://www.federalreserve.gov/pubs/feds/1997/199756/199756pap.pdf Hudson E. A., and D. W. Jorgenson (1978), Energy Prices and the U.S. Economy 19721976, Natural Resources Journal. Hunt B., Isard P. and D. Laxton (2001). The Macroeconomic Effects of Higher Oil Prices. International Monetary Fund working paper, WP/01/04. 21

Jones, D.W., Leiby, P.N., and I. K. Paik (2002). "Oil Price Shocks and the Macroeconomy: What Has Been Learnt since 1996". Proceedings of the 25th Annual IAEE International Conference, June 26-29, Aberdeen, Scotland. Document available at: http://pzl1.ed.ornl.gov/IAEE_2002_oil_macro_paper_rev2.pdf Nordhaus D.W. (2003), Economic Consequences of a War with Iraq, published in Kaysen C, Miller S.E., Malin M.B., Nordhaus W.D. and Steinbruner J.D. (2003), War with Iraq. Costs, Consequences and Alternatives, American Academy of Arts & Sciences. Perry, G. L. (2001), The War on Terrorism, the World Oil Market and the US Economy, Brookings Institution, Analysis Paper #7, 24 October 2001, available at http://www.brook.edu/views/papers/perry/20011024.htm.

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Annex 1. Regional Coverage of the GEM-E3 Model

Name of Region Australia and New-Zealand Japan China and Hong Kong India USA Canada Nordic EU Germany UK Other EU Other European countries South Asia South-East Asia

Countries included Australia, New-Zealand Japan China, HongKong India USA Canada Denmark, Finland, Sweden Germany UK Austria, Belgium, France, Greece, Ireland, Italy, Luxemburg, Netherlands, Portugal, Spain Iceland, Norway, Switzerland Bangladesh, Bhutan, Maldives, Nepal, Pakistan, Sri Lanka

Philippines, Malaysia, Singapore, Thailand, Vietnam, Indonesia, South Korea Mexico and Brazil Mexico, Brazil Argentina, Chile, Colombia, Venezuela, Bahamas, Barbados, Cuba, Dominican Republic, Haiti, Jamaica, Latin America Netherlands A., Trinidad, Uruguay, Belize, Guatemala, El Salvador, Honduras, Nicaragua, Panama, Costa Rica, Bolivia, Ecuador, Peru, Suriname, Guyana, Paraguay Czech Republic, Poland, Romania, Slovak, Slovenia, Central Europe Hungary, Bulgaria Russia, Armenia, Azerbaijan, Belarus, Estonia, Georgia, FSU Kazakstan, Kyrgyz, Latvia, Lithuania, Moldova, Tajikistar, Turkmenistan, Ukraine, Uzbekistan South Mediterranean and Turkey Turkey, Algeria, Egypt, Libya, Tunisia, Morocco Middle East Africa Rest of the World Bahrain, Iran, Iraq, Israel, Jordan, Kuwait, Lebanon, Oman, Qatar, Saudi Arabia, Syria, Arab Emirates, Yemen rest of African countries rest of the World countries

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Annex 2. Sectoral Coverage of the GEM-E3 Model


01 Agriculture. Agriculture and livestock production (paddy rice only). Agriculture Services (servicing paddy rice production only), Wheat Servicing wheat production only. Grains except wheat and rice. Servicing production of grains. Vegetables fruits and nuts. Oil seeds. Plant based fibers. Crops n.e.c. Bovine cattle, sheep and goats, horses. Animal products n.e.c. Raw milk. Wool, silk-worm cocoons. Forestry. Fishing. 02 Coal. Coal mining. Manufacture of miscellaneous products of petroleum and coal (briquettes only). 03 Oil. Petroleum refineries (except LPG). Manufacture of miscellaneous products of petroleum and coal (except briquettes). 04 Gas. Petroleum refineries (LPG only). Manufacture of Gas, distribution of gaseous fuels through mains. 05 Electricity. Production, collection and distribution of electricity. 06 Ferrous and non ferrous metals. Manufacture of basic iron and steel. Casting of iron and steel. Manufacture of basic precious and non ferrous metals. Casting of non ferrous metals. 07 Chemical Products. Processing of nuclear fuel. Manufacture of basic chemicals. Manufacture of other chemical products. Manufacture of rubber and plastic products. 24

08 Other energy intensive. Iron ore mining. Non ferrous ore mining. Stone quarrying, clay and pits. Chemical and fertiliser mineral mining. Salt mining. Mining and quarrying n.e.c. Manufacture of pottery, china and earthware. Manufacture of glass and glass products. Manufacture of structural clay compounds. Manufacture of cement, lime and paster. Manufacture of non metallic mineral products. Manufacture of pulp, paper and paperboard. Manufacture of containers and boxes of paper and paperboard. Manufacture of pulp, paper and paperboard articles n.e.c. Printing publishing and allied industries. 09 Electronic Equipment. Manufacture of office, accounting and computing machinery. Manufacture of radio, tv and communication equipment and apparatus. 10 Transport equipment. Manufacture of motor vehicles, trailers and semi trailers. Manufacture of other transport equipment. 11 Other Equipment Goods. Manufacture of engines and turbines. Manufacture of agricultural machinery and equipment. Manufacture of metal and wood working machinery. Manufacture of special industrial machinery and equipment except metal and wood working machinery. Manufacture of office, computing and accounting machinery. Machinery and equipment except electrical n.e.c. Manufacture of electrical and industrial machinery and apparatus. Manufacture of radio, tv and communication equipment and apparatus. Manufacture of electrical appliances and house wares. Manufacture of electrical apparatus and supplies n.e.c. Manufacture of professional and scientific and measuring and controlling equipment n.e.c. Manufacture of photographic and optical goods. Manufacture of watches and clocks. Manufacture of cutlery, hand tools and general hardware. Manufacture of furniture and fixtures primarily of metal. Manufacture of structural metal products. Manufacture of fabricated metal products except machinery and equipment n.e.c. 25

12 Other Manufacturing products. Sawmills, planing and other wood mills. Manufacture of wooden and cane containers and small cane ware. Manufacture of wood and cork products n.e.c. Manufacture of furniture and fixtures except primarily of metal. Manufacture of jewelry and related articles. Manufacture of musical instruments. Manufacture of sporting and athletic goods. Manufacture of industries n.e.c. 13 Construction. 14 Food Industry. Distilling, rectifying & blending spirits. Wine industries. Malt liquors and malt. Soft drinks & carbonated waters industries. Tobacco manufacturers. Canning and preserving of fruits and vegetables. Canning, preserving & processing of fish, crustaceans and similar foods. Manufacture of vegetable and animal oils and fats. Grain mill products (except processed rice). Manufacture of bakery products. Sugar factories and refineries. Manufacture of cocoa, chocolate and sugar confectionery. Manufacture of food products n.e.c. Manufacture of prepared animal feeds. Sugar. Grain mill products (processed rice only). Manufacture of dairy products. Vegetable oils and fats. Meat products. Bovine cattle, sheep and goat, horse meat prods. 15 Trade and Transport. Wholesale trade. Retail trade. Restaurants, cafes and other eating and drinking places. Hotels, rooming houses, camps and other lodging places. Railway transport. Urban, suburban and interurban highway passenger transport. Other passenger land transport. Freight transport by road. Pipeline transport. 26

Supporting services to land transport. Ocean and Coastal transport. Inland water transport. Supporting services to water transport. Air transport carriers. Supporting services to air transport Services incidental to transport. Storage and warehousing. Communication. 16 Textile Industry. Manufacture of textiles. Manufacture of man-made fibers. Manufacture of wearing apparel, dressing and dyeing of fur. Tanning and dressing of leather, manufacture of luggage, handbags, saddlery, harness and footwear. 17 Other Market Services. Monetary Institutions. Other financial institutions. Financial Services. Insurance. Real estate. Legal services. Accounting, auditing and bookkeeping services. Data processing and tabulating services. Engineering, architectural and technical services. Advertising services. Business services, except machinery and equipment rental and leasing. Machinery and equipment rental and leasing. Motion picture production. Motion picture distribution and production. Radio and television broadcasting. Theatrical producers and entertainment services. Authors music composers and zoological gardens, and other cultural services. Amusement and recreational services. Repair of footwear and other leather goods. Electrical repair shops. Repair of motor vehicles and motorcycles. Watch, clock and jewelry repair. Other repair shops. Laundries, laundry services and cleaning and dyeing plants. Domestic services. 27

Barber and beauty shops. Photographic studios, including commercial photography. Personal services. Collection, purification and distribution of water. Dwellings. 18 Non Market Services. Public administration and defense. Sanitary and similar services. Education services. Medical, dental and other health services. Veterinary services. Welfare institutions Business, professional and labor associations. Religious organizations. Social and related community services n.e.c. International and other extra territorial bodies.\ 19 Crude Oil. Crude Petroleum & natural gas production (oil only). 20 Natural Gas. Crude petroleum and natural gas production (gas only)

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Annex 3. Implementation of the Oil Price Shocks in the Model

The alternative scenarios have been implemented in the GEM-E3 model in the following way: (1) The lower accessibility of the oil reserves in the Middle East region provokes a shortage of supply. Such a fall in oil production translates into an increase, relative to the baseline, of 30% and 90% in Scenarios 1 and 2, respectively. (2) In order to have the same oil price across all regions of the model, a dummy levy on oil production was imposed. (3) The revenues from that production levy are recycled to firms.

29