Oil Funds: Problems Posing as Solutions?

• Author: Jeffrey Davis, Rolando Ossowski, James Daniel, and Steven Barnett
• Position: Assistant Director/Advisor/Deputy Division Chief/Economist in the IMF's Fiscal Affairs Department

Heavy dependence on oil revenues-which are volatile and unpredictable, and will, sooner or later, dry up- greatly complicates a country's fiscal policy. To tackle these problems, many oil-producing countries are setting up oil funds. But are these really a solution, or just a problem posing as one?

Oil funds have become fashionable in the wake of recent high and volatile oil prices and new discoveries. In recent years, many countries have either established oil funds or are considering doing so. These funds have different rules and names, but their objectives are the same: to help governments deal with the problems created by large oil revenues.

Rationales

Oil funds are usually designed to address the problems created by the volatility and unpredictability of oil revenues ("stabilization" funds), the need to save part of the oil revenues for future generations ("savings" funds), or both.

Because oil prices are volatile and unpredictable (see chart), so are oil revenues. This means that actual revenues often differ greatly from budget projections, which, in the case of shortfalls, requires offsetting fiscal adjustment (typically, decreased spending) or financing. Cutting spending sharply at short notice is costly. Current expenditure cuts can be notoriously difficult and unpopular, and cutting capital spending might mean abandoning viable projects that are crucial to a country's development. Countries could decide not to cut spending but to finance the revenue shortfall instead. But many countries do not have large financial assets to run down and are constrained in their borrowing (especially when their oil revenues are low). If the oil revenue shock (typically created by a sharp decline in world oil prices) is permanent, financing the shortfall is unsustainable. Dealing with higher-than-expected oil revenues is easier, but still difficult to do efficiently: spending money quickly often means spending it poorly. And hanging over every project started when oil prices rise is the threat that it may be scrapped when they fall.

[ SEE THE GRAPHIC AT THE ATTACHED RTF ]

Stabilization funds aim to solve this problem of volatile and unpredictable oil revenues. When oil revenues are high, the argument runs, some part of these would be channeled from the budget to the stabilization fund; when oil revenues are low, the stabilization fund would finance the shortfall. This would stabilize budgetary revenue and thus budgetary expenditure. But this rationale is flawed.

The international price of oil does not appear to have a constant average, or at least not one to which it reverts in a practical period of time. Thus, one cannot say with confidence that oil prices will fall or rise in the future or that a price change is temporary or permanent. Stabilization funds governed by rules that assume otherwise face either continuous accumulation or rapid exhaustion of resources. The way oil prices behave helps explain why many domestic and international commodity price stabilization schemes collapsed or were terminated during the 1980s and 1990s. Stabilization funds can avoid this problem by linking the oil price at which they receive resources from, or transfer them to, the budget to the actual price (for example, a three-year moving average of oil prices). This course of action, however, would make smoothing, rather than stabilizing, public finances the funds' objective.

It is doubtful that stabilization funds will be able to achieve...