Rising Oil Prices Highlight Need for Diversification

Countries have built up some resilience to oil spikes but remain vulnerable

Diversification in sources of oil, natural gas supplies provides cushion

Policy response to oil spikes should be multilateral, multipronged

Nevertheless, while countries have built up some ability to withstand oil price shocks and some are less sensitive, they remain vulnerable to severe supply disruptions or to the uncertainty induced by extreme oil price volatility, highlighting the need for a continuing multipronged policy response that has three main elements.

• Bolstering oil supplies and investment;

• Increasing the responsiveness of oil demand to price signals; and

• Nudging along a transition from oil to other fuels and renewable sources of energy.

Need to boost investment

On the supply side, increased investment in the oil sector is crucial in bringing greater stability to oil prices. Surges in oil prices in recent years have resulted in only very modest increases in capacity. The sluggish response appears due to rising exploration and development costs and the lack of predictable regulatory and tax regimes that would provide adequate returns for expanding supply and infrastructure. Political turmoil of course makes it all the more difficult to sustain increased investment.

Strengthening the demand response to oil price changes is critical as well. In 2008, IMF First Deputy Managing Director John Lipsky noted that “relatively low gasoline taxes in the United States, low domestic prices in China, and heavily subsidized and controlled prices in many oil-exporting and other developing countries discourage” the demand-side response that is needed. Policies to increase energy efficiency, for instance through better fuel-efficiency standards, can strengthen the demand response.

Increasing diversification

The recent volatility follows a roller coaster ride in which oil prices rose from $35 in 2004 to over $140 in July 2008, only to plunge back to $35 by the end of that year (see Chart 1).

Oil price spikes in the mid-1970s and early 1980s are widely believed to have contributed to the recessions that followed in the United States and many other countries. Since that time oil importers have taken a number of steps to increase their resilience to such shocks.

One key step is diversification. As documented in recent IMF research, many countries have increased the number of sources from which they import oil, making them less vulnerable to disruptions...