Macroeconomic Tradeoffs and Energy Security for Thailand ...

Macroeconomic Tradeoffs and Energy Security for Thailand:

The Case for Strategic Petroleum Reserve – An Application of Dynamic Programming

Presented at the Division of Economics and Business

The Colorado School of Mines

September 30th, 2011

Poonpat Leesombatpiboon

Energy Policy and Planning Office

Ministry of Energy

121/1-2 Phetchaburi Road

Ratchathewi, Bankok 10400

Thailand

Fred Joutz

The George Washington University

Department of Economics

[email protected]

Abstract

“Small oil-importing economies” are subject to risk from oil price and quantity shocks. Strategic Petroleum

Reserves (SPR) are one policy option. Government policy makers can attempt to mitigate the macroeconomic

impacts, but have to balance the welfare impacts from allocating resources to SPR against other energy and

macroeconomic development goals. We develop a simple dynamic stochastic general equilibrium policy model to

analyze the economic consequences of the SPR for Thailand. The assigned parameter values for the model aim to

reflect the basic characteristics of Thai economy. We examine the welfare effects from alternative sizes of the SPR

and the opportunity cost for the economy. The larger is the SPR, the greater are the sacrifice of resources to

maintain and operate the SPR. This lowers the level of resources available for production and consumption in the

long run. There exists a tradeoff between the sacrificed welfare in the long run for the less volatile welfare in the

short run.

Outline

1. Thailand Energy Balance

2. Energy Security - Definitions

3. Rationale for a Strategic Petroleum Reserve

4. Brief Review of the Literature

5. The SPR Model

6. Simulations and Impulse Responses

7. Summary

The Energy Balance in Thailand

Commercial Primary Energy Production, Consumption and Import

0

10000

20000

30000

40000

50000

60000

70000

80000

90000

1980 1985 1990 1995 2000 2005

Energy Import (Net)Energy ProductionEnergy Consumption

Thousand T

ons o

f O

il E

quiv

ale

nt

(KT

OE

)

Figure 3: Net Energy Import by Energy Type

-10000

0

10000

20000

30000

40000

50000

86 88 90 92 94 96 98 00 02 04 06

Crude OilCoalCondensate

ElectricityNatural GasPetroleum Products

Thousand T

ons o

f O

il E

quiv

ale

nt

(KT

OE

)

Energy Security is defined and used in many fields, ranging from economics to law, public policy, and foreign

affairs.

The essence focuses primarily on the importance of secure energy supply sources at reasonable prices in the short

and long term and the threats to energy infrastructure that can damage the smooth and stable flow of energy

supplies.

APERC1 (2007) defines energy security as the ability of an economy to guarantee the availability of energy

resource supplies in a sustainable and timely manner with energy prices maintained at a level that will not

adversely affect economic performance.

Conceptually summarized into four A’s: Availability, Accessibility, Acceptability, and Affordability

Important Issues When Discussing Energy Security

(1) the availability of fuel reserves,

(2) the accessibility energy supplies to meet energy demands,

(3) the ability of an economy to diversify both energy types and energy suppliers,

(4) the availability of energy infrastructure and transportation,

(5) the impacts of geopolitical concerns, and

(6) policies that promote energy efficiency and conservation

1 Asia Pacific Energy Research Center is the energy research entity under the APEC Energy Working Group. More information can be found at www.aperc.org.

Rationale for a Strategic Petroleum Reserve

Leesombatpiboon (2009)

10 percent shortfall in oil consumption might cause Thailand’s economic growth to shrink by 2 percent within the

same year

While a sharp 10 percent rise in oil price can lead to a fall in output growth by 0.5 percent.

Sources of Global Oil Supplies are most often found in unstable geopolitical locations and subject to transportation

chokepoints.

Volatile sources of Supply

These unfavorable scenarios require the government to establish an emergency plan rather than just relying on oil

price controls and rationing programs.

Pindyck and Rotemberg (1984) argue that price controls can eventually turn a price shock into a quantity shock.

Cohen, Joutz, and Loungani (2011)" Quantifying Energy Security"

Rationale for a Strategic Petroleum Reserve

Market Failures

The first externality refers to excessive oil imports from politically insecure parts of the world. The private cost of

imported oil is the price of imported oil plus shipping costs and insurance premiums. This private cost is lower

than the social cost as individuals do not take into account the costs to society imposed by the insecurity that

accompanies imported oil. This sort of externality can be corrected with an “oil import premium” as suggested

by Bohi and Montgomery (1982).

The second type of market failure occurs because, in the absence speculative action, the private sector tends to

keep its oil stocks as low as possible in order to minimize operating costs. The Stockpile premium. The private

stock level is therefore lower than is socially optimal in the sense that it is insufficient to cushion

The national oil stockpile in this case exhibits a characteristic of public good as it provides security to the nation

and the economy as discussed by Horwich and Weimer (1984). But one country's or a group of countries' (IEA) oil

stockpile has benefits that can disseminate globally. Even countries that are not IEA members can benefit from

such action, which creates a classic example of the free-rider problem.

Brief Literature Review on SPRs

IEA

Balas (1979) Game Theoretic Approach for US

Teisberg (1981) Dynamic Programming examined different sizes of oil shocks and optimal size of SPR

Bohi and Montgomery (1982) describe the economic benefits and costs of oil stockpile. They address interesting

policy questions e.g. the optimal use of oil in the normal and disruption period together with the optimal size of the

oil stockpile to be held for alleviating the supply disruption.

Eckstein and Eichenbaum (1985)

Lougani and Kim (1992) to construct a stochastic general equilibrium model of an economy that cannot produce

oil and must import oil as an input of domestic production.

The SPR Model

Objective to examine the welfare effects of government intervention to establish a strategic petroleum reserve in a

small open fuel importing country that is subject to the uncertainties of oil supply shocks. Follow Eckstein and

Eichenbaum (1985) and Lougani and Kim (1992) approach to construct a stochastic general equilibrium model

Economy

1. Infinitely lived consumers supplying labor and renting capital to firms. Consumers maximize discounted

utility from consumption and leisure.

2. Simple capital accumulation equation

3. Oil stock evolution

4. Firms maximize profits producing the single good using capital , labor, and energy (oil)

5. Government chooses the size of the strategic petroleum reserve.

Steps

1. Describe the Consumers Problem and the Firms Problem

2. Set up the Dynamic Programming Problem and Bellman Equations

3. Solve the Optimality Conditions

4. Examine the Equilibrium and Model Solution

5. Simulations with types of shocks, their size, and different SPR sizes

The Representative Consumers Problem

The representative consumer derives the well-being at time t from consumption, tc and leisure, tl . The

consumer’s time endowment is normalized to 1 so that after allocating the amount of time tn for working, his

leisure is equal to )1( tn . The utility function is given by

)1log(log),( tttt nAcncU (1)

where A is a positive constant term. Utility increases in consumption and leisure while marginal utility of

consumption and leisure decline in consumption and leisure respectively.

The single period budget constraint of the representative consumer is given by

ttttttt krnwic (2)

Dynamics of Capital Accumulation or Law of Motion for Capital

ttt ikk )1(1 (3)

where 10 is capital depreciation rate.

Evolution of the Oil Stock

to , Oil use in this period,

tH , availability of oil holding,

ts , the stockpile of the amount of oil reserved from the last period

tM the delivery of oil import in the current period was ordered/decided in this previous period.

ttM The realization of oil imports from Aiyagari and Riezman (1985).

]1,0[t the random oil disruption variable - independently and identically distributed (iid).

The availability of oil holdings in this period is given by firm which recalculates its available oil stock and makes

the optimal decision for oil use in period t i.e. to and oil to be reserved from this period to the next period, 1ts .

tttt sMH (4)

The amount of oil use in this period and the amount of oil saved for the next period cannot exceed the availability

constraint of oil holdings in the same period i.e.

ttt Hso 1 (5)

The constraint is assumed to be binding since the firm makes the most efficient use of its oil resource.

1ttttt ssMo (6)

The Representative Firms Problem

The representative firm has a Cobb-Douglas production technology which exhibits the constant return to scale.

Three inputs are used for production: capital, labor and oil. The production function can be written as

321

tttt noky (7)

The firm maximizes the present value of expected profit by producing the single consumption good ty

and paying the following costs

1) labor cost, ttnw

2) capital rental cost, ttkr

3) oil import cost, 1t tp M

4) oil stock holding cost h and

5) oil adjustment cost. 2)(

2ttt sM

where is the adjustment cost parameter and 10 is the required stock holding parameter set by

government. .

The Representative Firms Problem The Current Period Profit Function

211 )(

2321

tttttttttttttt sMhsMpnwkrnok

(8)

Substitute Equation (6) in Equation (8), the profit function can be written as

31 2 21 1 1( ) ( )

2t t t t t t t t t t t t t tt t tk M s s n r k w n p M hs M s

(9)

The Economy's Resource Constraint is given by:

31 2 2

1 1 1 11 ( ) ( )2

t t t

t t t t t t t t t t t t t t t

c i y

c k k k M s s n p M hs M s

Set up the Dynamic Programming Problem and Bellman Equations

Representative Consumer Maximizes the subjective discounted value of utility by choosing the sequence

1, ,t t tc n and k subject to the lifetime budget constraint and the equation of motion for capital.

1

, , 0 01

ln ln 1

ln ln 1 1

ln ln 1 1

1max ,

1

t t t t

t t t t t

t t t t t t

T Tt

t t t t t t t tic n k t it t t t i

Using the Bellman Equation Framework

V k c B n V k

V k c B n V k i

V k c B n V k y c

V U c n w n r k cr

The Firm maximizes the discounted stream of profits by choosing

31 2

1 1

1 1

21 1 1

, , , 0

1, , ,

1max ( ) ( )

21

max

t t t t

t t t t

T

t t t t t t t t t t t t t tt t t tn k M s t t

t t tn k M s

k M s s n r k w n p M hs M sr

V s E V s

We assume the firms and consumers use the same discount rate.

Solve the Representative Consumer's Optimality Conditions

)]1([1

1

1

t

tt

rcc

(10)

(10) This is the intertemporal MRS which states that the marginal utility of giving up one unit of consumption in

the present is compensated by the discounted increase in utility in the future taking into account the net interest

income earned from future capital.

A

nwc tt

t

)1(

(11)

(11)This is the MRS for leisure and consumption. The optimality condition determining labor supply in every

period by taking into account the real wage, tw , which is implicitly determined in the model. It implies that for

any given level of consumption, tc , an increase in the real wage, tw , will increase labor supply, tn . This is

assuming the substitution effect dominates the income effect.

Solve the Representative Firm's Optimality Conditions

The optimal condition for tk is given by setting the rental rate to the MP of capital

321 )( 11

1 ttttttt nssMkr (12)

The optimal condition for tn is given by setting the real wage to the MP of labor

113

321 )( ttttttt nssMkw (13)

The optimal condition for 1tM is given by the price of oil paid by the firm today is equal to the discounted

expected MP of oil and including the adjustment cost from using one barrel of oil next period.

)]}()([{ 11111

2111121321

tttttttttttt sMnssMkEp (14)

The optimal condition for 1ts is given by MC of foregoing a barrel of oil consumption today plus the holding cost

being set equal to the discounted expected benefit of an additional barrel of oil expected MP of oil and including

the adjustment cost from using one barrel of oil.

)}()({)( 11111

2111121

12321321

tttttttttttttttt sMnssMkEhnssMk (15)

Examine the Equilibrium and Model Solution

The equilibrium solutions of the model must satisfy three conditions i.e.

1) the consumer chooses consumption and leisure optimally, given the market prices;

2) the representative firm chooses the levels of capital, labor, oil imports and oil reserve optimally, given the

market prices;

3) All markets clear.

In other words, the competitive equilibrium solutions will be obtained by solving the optimal conditions of

consumer and firm simultaneously along with the resource constraint. As a result, consumer takes the price of

capital and labor defined in (12) and (13) and substitutes them into (10) and (11) respectively which give Equations

(16) and (17) as follows:

)]1()([1

321

121111

11

1

tttttt

tt

nssMkcc

(16)

A

nnssMkc ttttttt

t

)1()(1

13321

(17)

The resource constraint is given by

21111 )(

2)())1(( 321

ttttttttttttttt sMhsMpnssMkkkc

(18)

By solving the system of nonlinear equations consisting of Equations (14) to (18), the optimal path of the choice

variables can be determined. Let * * * * *, , , ,c n k M and p denote the steady-state values of consumption, labor

employment, capital stock, oil import, oil stock and oil price respectively. In the steady state, we assume there is

no oil supply shock i.e. 1*.

1

1

**2

** 2

31 )()())1(( nk

hpM

(19)

321 )()()()1(1 *1**

2** nMkhMs

(20)

11

1

32 )()(

)1(1

**1

*

nMk

(21)

A

nnMkc

)1()()()( *1***3*

321

(22)

3

1

21 )()(

)(2

**

*2******

*

Mk

ksMhsMpcn

(23)

Lets consider implications of the steady-state equation for oil imports and oil stockpile.

This can aid in understanding the long-run relationship between these variables when all shocks have disappeared

and the economic environment turns to normal.

(20) suggests that the steady-state level of oil stock is positive only if the value of the first term on the right hand

side of the equation exceeds the second term. The first term on the right hand side is the required stock set by the

government as a proportion of steady-state oil import level while the second term is based on the firm’s marginal

cost of holding the stock in the steady state.

If the adjustment cost, , (i.e. punishment cost in some sense) is very high, the second term will approach to zero.

Firms are forced to follow the government’s stock requirement in the steady state. Otherwise if the firm perceives

that it is worthwhile to violate the government’s rule due to the low adjustment cost, the stock level in the steady

state could turn out to be negative. This violates a physical constraint and is counterintuitive. Therefore, in the

simulation part, it is necessary that the parameters must be chosen carefully to ensure that the steady-state stock

level will not be negative.

(19) implies that holding other variables constant, the steady-state level of oil imports is inversely related to the

steady-state oil price. What about the impact of capital and labor on imports?

0)()))(1((1 31

2

2

*1*2

*1

2

2

1

*

*

nk

hp

k

M

0)()))(1((1 31

2

2

1**2

*1

2

2

3

*

*

nk

hp

n

M

31 )()))(1(( **2

*

nk

hp

Parameterizing the Model

Table 4: Baseline Parameter Values

A 1 2 3 *p

* h

0.97 1.53 0.13 0.19 0.68 0.05 1.058 1.57 1.00 0.00012 10 0.35

With the given parameters in Table 4, the steady-state values of the interested variables can be computed and the

results are reported in Table 5.

Table 5: Steady-State Values of Key Variables

*c *n

*k *M

*s *y

0.1796 0.3764 0.3861 0.0286 0.0049 0.2439

Model Simulation - Impulse Response to Oil Shocks

Oil shocks only take place once and at the beginning of the period when the economy is in its steady state.

*

*

0 1,

0 1

, 0.8

t

p p

t

p

where

p p where

and assume Corr

(25)

Then, the economy responds to the shocks by drawing from the SPR. There is an adjustment back to the steady

state afterwards. The impulse response of the variables will provide an insight into the dynamic behavior of key

variables.

Oil Supply Shocks and Impulse Responses of

Capital Stock, Labor Employment, Consumption and Welfare

-.04

-.02

.00

.02

.04

.06

.08

.10

5 10 15 20 25 30 35 40

10% shock

30% shock

50% shock

Capital

-.04

-.03

-.02

-.01

.00

.01

5 10 15 20 25 30 35 40

Labor Employ ment

-.05

-.04

-.03

-.02

-.01

.00

.01

5 10 15 20 25 30 35 40

Output

-.009

-.008

-.007

-.006

-.005

-.004

-.003

-.002

-.001

.000

5 10 15 20 25 30 35 40

Consumption

-.06

-.04

-.02

.00

.02

.04

.06

.08

5 10 15 20 25 30 35 40

Welf are

Growth rate of key variables in the first three periods with different size of SPR (Unit: Percent)

Size of the SPR

9 days 63 days 117 days

Output 1st period: -3.92 -3.01 -2.29

2nd

period: 0.17 -0.81 -1.40

3rd

period: 3.35 2.99 2.59

Oil Import 1st period: -78.60 -61.90 -49.54

2nd

period: 572.89 239.06 135.88

3rd

period: -25.88 -16.54 -10.48

Consumption 1st period: -0.23 -0.23 -0.22

2nd

period: -0.79 -0.68 -0.59

3rd

period: 0.05 -0.02 -0.06

Employment 1st period: -2.30 -1.74 -1.29

2nd

period: 0.60 -0.07 -0.50

3rd

period: 2.01 1.84 1.62

The shock is 10% of annual consumption. Consider the cumulative Effects of the shocks.

A Possible SPR-Welfare Tradeoff Matrix

Considering Short-run and Long-run

Size of SPR

Occurrence of Oil Shocks for a

Given Size

Small Large

Infrequent

0

??LR

SR

W

W ambiguous

0

0LR

SR

W

W

Frequent

??

0LR

SR

W ambiguous

W

0

0LR

SR

W

W

Issues:

Can Oil Shocks affect long-run growth?

Paying the full or higher social costs of oil consumption for economies vulnerable oil shocks by an SPR can lead

to lower oil consumption in short-run and long-run.

SPR is not the panacea. It is one tool in a National Energy Policy

Summary

Comments and Suggestions Welcome

Thank You