Research Background

Energy price shocks are generally acknowledged to have important effects on both the economic activity and macroeconomic policy of industrial countries. Huge and sudden rises in energy prices increase inflation and reduce real money balances with negative effects on consumption and output. Among the most acute supply shocks hitting the world economies since World War II are sharp increases in the price of oil and other energy products. Figure 1.1 shows the annual average energy price (oil price, natural gas price, and coal price) from 1983 to 2009.

Figure 1.1 World Marketed Energy Price, 1983-2009

0 50 100 150 200 250

1983 1984 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2006 2007 2008

US Dollars per Barrel\Metric Ton

Oil price (WTI) Natural gas price (Russia) Coal price (Australia) invaded

Kuwait

Asian financial crisis

OPEC production restraint

Iraq War

Hurricane shut down production Yukos Bankruptcy and Strikes in Nigeria

Coal price Oil price

Gas price increase

Saudi production

Iraq

Since the 1970s, oil price in the world market has experienced fluctuations including sharp rises during the first and second oil crises. During the periods of 1973-1974 and 1978-1979, when the Organization of Petroleum Exporting Countries (OECD) first imposed an oil embargo and the Iranian revolution disrupted oil supplies, the prices of a barrel of oil increased from $3.4 to $30. In 1990, prices rapidly rose from $16 to $26 after the Gulf War. Finally, due to a decline from the Asian financial crisis in 1999, prices fell from $20.28 to $11.13. Since 2000, oil prices have continued an upward trend with repeated fluctuations. In particular, oil price volatility in the crude oil market has risen during 2004 to 2008. By March 13, 2008, the oil price had spiked to a historical high of $110.21 per barrel (West Texas Intermediate (WTI) spot).

Recently, the WTI oil future prices averaged $76 per barrel in October 2009 on the New York Mercantile Exchange (NYMEX). This is an increase of just over 8 percent for this month. EIA (2009) estimates that the January 2010 WTI futures contract consistent with this volatility was $61 per barrel at the lower limit and $104 per barrel at the upper limit for the 95 percent confidence interval.

Higher prices of oil driving demand for other energy have made natural gas and coal more competitive (see Figure 1.2). From 1986 to 1999, natural gas prices averaged $1.87 per million cubic feet (mcf), with a standard deviation of $0.24 per year (Kliesen, 2006). Since 2001, natural gas prices began to rise noticeably. Natural gas prices in both real and nominal dollars were at record-high levels by 2005. In 2008, natural gas prices averaged approximately $9 per mcf. Because price-setting is based on production costs and applications for rate increases move slowly through the bureaucratic process, natural gas volatility is quite small. On average, natural gas price variability is 3%-4%.

Natural Gas (average 106.3) Coal

(average 123.2)

Nuclear (average42.7) Renewables

(average 26.9)

0 50 100 150 200

1980 1989 1998 2007 2016 2025 Year

Quadrillion Btu

Figure 1.2 World Marketed Energy Use by Fuel Type, 1980-2030

Sources: Energy Information Administration, International Energy Annual 2006

Coal is similarly the primary factor for industrial revolution in the world. In 2006 coal was the world’s fastest-growing used fuel with global consumption rising by 5%

per annum. The monthly average coal price reached a record high of $208.55 per mcf in 2008. Coal prices saw severe fluctuations during 2003 to 2009.

At the regional level, oil is of particular importance to many Asian economies as most are net importers of this energy product. Because Taiwan is an island with limited indigenous energy resources and energy imports are over 99.32% in 2008, Taiwan has been identified as one of six Asian economies (including Japan, Philippines, Singapore, South Korea, Taiwan, and Thailand) that are considered to be easily subjected to world oil price fluctuation (Aoyama and Berard, 1998). Figure 1.3 illustrates the co-movement of Taiwan’s domestic energy prices indices (including fuel oil, coal, natural gas, gasoline, and diesel oil) with fluctuations of the WTI oil price index since 1971. We observe that the former variables are linked to the latter’s trend.

0 50 100 150 200 250 300

1971 1975 1979 1983 1987 1991 1995 1999 2003 2007

US Dollars per Barrel

WTI Gasoline Diesel Oil Fuel Oil Coal Natural Gas

Figure 1.3 The Co-movement Between Domestic Energy Price Index and WTI Oil Price Index, 1971-2008

Domestic energy price-setting is relatively affected by projected world oil prices in the past several years. Jiménez-Rodríguez and Sánchez (2005) report that oil price increases have a direct impact on economy activity for oil-importing countries. Indeed, rising oil prices are interpreted as an indicator of an increase in scarcity and that means oil will be less available on the domestic market. This phenomenon is expected to keep the domestic energy price at high levels over the near term.

World oil shocks not only directly affect domestic energy prices, but also imply the importance of domestic renewable industry development. To expedite domestic energy diversity as well as improve environment quality, a number of Taiwan’s factories have developed a renewable industry since 1998. Through Taiwan’s innovative pattern of learning-by-doing which borrows much production knowledge from its

semiconductor production, the renewable industry such as photovoltaic is currently in the value inflow stage (Hu and Yeh, forthcoming). Compared to other countries, Taiwan ranks as the fourth largest solar cell producing country in the world. The empirical analysis of this dissertation highlights the status of its importance.

In sharp contrast to the volume of studies examining the link between oil price shocks and macroeconomic variables, there is currently not much existing literature on quantitative analyses of coal-price or gas-price shocks. There are also few analyses on the relationship between oil price shocks and financial markets such as the stock market. Market participants want a framework that identifies how energy price changes affect the stock market and labor market.