Friday, July 31, 2009

Barrels and Big Macs

Dealing with sudden inflows of oil revenue would at first glance seem like a problem any nation would gladly welcome.

However, if oil accounts for an unusually large share of a nation's total exports it can result in the currency of that nation rising too rapidly for non-oil parts of the economy to adjust. The problem is exacerbated by the cost of labor and real estate in that country surging. The currency strengthens and costs become high because of the constant and rapid flow of US dollars in and physical oil, rather than the nations currency, flowing out.

Strong currencies and high costs make it difficult for non-oil exporting industries in a nation to compete internationally.

Oil exporting nations end up with an oil industry and little else. When oil production eventually declines, or oil prices fall, the nation has nothing to fall back on. This is known as Dutch disease and is described further in Oil 101.

The solution to Dutch disease is to try to keep oil revenues invested overseas and to bring it back only when the nation's oil industry begins to wane. This is, of course, extremely challenging to implement. People want money to be spent now and politicians know that one of the surest (but often most reckless) ways to stay in power is to spend money now.

The oil exporting country which is held up as the epitome of avoiding Dutch disease is Norway. Norway is the third largest oil exporter in the world behind Saudi Arabia and Russia. Norway has a very large petroleum fund which keeps revenue invested overseas. Despite this, Norway is an expensive country to live in.

The Economist magazine, which coincidentally coined the term"Dutch disease" in the 1970s, produces a survey of the cost of a McDonald's Big Mac hamburger in various countries across the world. The survey is both a serious and light-hearted method of determining the relative costs of living.

The latest Economist Big Mac Index survey just published shows that a Big Mac in Norway is the most expensive in the world at US$6.15, which is 72% above the same hamburger in the US (US$3.57). Other oil exporting nations didn't fare as badly and most are surprisingly less expensive than the US:

Undervalued vs. the US (local Big Mac price in US$)
Malaysia -47% ($1.88)
Russia -43% ($2.04)
Mexico -33% ($2.39)
UAE -24% ($2.72)
Saudi Arabia -18% ($2.93)
Canada -6% ($3.35)

Overvalued vs. the US
Brazil +13% ($4.02)
Norway +72% ($6.15)

One might think that the high cost of Big Macs in Norway is a recent phenomenon following the run up in oil prices during 2008. However, looking at the following chart of the Big Mac index over the past four years, it shows the persistence by which costs in Norway have remained high.

(source: Bloomberg chart of Economist Big Mac Index - click to enlarge)

Other methods of calculating relative costs, such as those carried out by the OECD, show costs in Norway to be 24% (source: OECD data from Bloomberg) above that of the US. So when a more rigorous and comprehensive analysis is performed the cost disadvantage of Norway may not be as dire as the Big Mac index suggests - but the symptoms of Dutch disease still persist.

The US$325billion (approx. US$70,000 per citizen) Norwegian offshore petroleum fund is large, but perhaps still not large enough to cure Dutch disease.
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