Hamed Ghoddusi

Islamic Finance and the Energy Sector

This paper analyzes existing experiences with Islamic financing of energy projects. We argue that Islamic finance provides an additional channel to attract financial resources to improve energy efficiency, access to energy, and a sustainable energy supply. Major forms of Islamic finance methods used in the energy sector (including gas, petrochemical, and power projects) are reviewed based on real-world cases. A review of the limitations of Islamic finance in the energy sector and a set of policy recommendations are offered.

Virtual Water Trade: The Implications of Capital Scarcity

The original idea behind the virtual water (VW) concept is that water-abundant countries will become producers of water-intensive goods and consequently net exporters of water, and this will alleviate the initial unequal distribution of hydric resources. We criticize this optimistic view by introducing empirical evidence that is consistent with the Heckscher-Ohlin model of international trade. We find that, though virtual water exports are increasing in the combined availability of water and arable land when comparing countries with a similar level of available water-land resources, those with higher (lower) levels of physical-human capital tend to be net importers (exporters) of water. This result relies on the intuition that high levels of capital accumulation lead water to become a relatively scarce factor in developed countries. Thus, while more developed countries shift away from agriculture, less developed countries that lack sufficient capital do not have this option and end up using water resources even if they are not abundant. Such a trade pattern could create immediate economic benefits for less developed countries, but also exerts pressure on their water resources. Therefore, prioritizing economic development in countries that have limited water availability, may be crucial to avoid excessive usage and depletion of global water resources.

Income Elasticity of Demand Versus Income Elasticity of Consumption

The income elasticity of consumption depends not only on the demand function but also on the characteristics of the supply function. If supply is not completely elastic, the income elasticity of consumption will be less than the income elasticity of demand, with the difference depending on the shapes of both the demand and supply functions. We show if supply is sufficiently inelastic, extending the individual level estimates of the income elasticity of demand to aggregate values can produce erroneous and misleading policy conclusions. We suggest that the economics teaching and analysis carefully distinguish between the income elasticity of consumption for a good in a specific market (the observable quantity) and the income elasticity of demand (an unobservable function).

Crude or Refined? Rationality of Downstream Investment for OPEC Members

Should oil-rich countries aggressively move toward downstream and invest in the oil refinery industry? This is a crucial energy policy question for such economies. We offer theoretical models for a vertical integration strategy (i.e. downstream investment) within an oil-producing economy. The first model highlights the trade-off between return and risk-reduction features of upstream/downstream sectors. The dynamic model demonstrates the volatility of total budgetary revenue of each sector. We motivate the discussion in the context of OPEC countries. Our theory-guided empirical analysis shows that the average markup in the refining sector is significantly smaller than the profits in the upstream; thus, not much economic value-added can be expected through vertical integration. We, however, find that from a hedging prospective the more stable and mean-reverting refining margins may provide a partial revenue cushion when crude oil prices are low. The analysis can inform energy sector investment decisions as well as export diversification policies of oil producing countries.

The Expected Hitting Time Approach to Optimal Price Adjustment Problems

We offer a novel approach for solving optimal price adjustment problems, when the underlying process is a Geometric Brownian Motion (GBM) process. Our approach relies on characterizing the cumulative cost of deviation and the cost of adjusting price until the hitting time of the lower or upper barriers. Using this approach, we are able to derive an analytical expression for the cost function, that does not require solving a PDE or running Monte-Carlo simulations. We apply our framework to the real world problem of adjusting domestic energy prices in countries that adopt administratively-set energy price rules. Our toolbox code in Matlab can be easily modified to be used to calculate optimal policies in a wide range of topics in finance, operations management, economics, and natural resource management.

The Option Value of Mortgage Interest Tax Deductibility

We offer a continuous-time contingent claims valuation framework to quantify the tax shield value of US mortgage interest deduction (MID) under uncertainty. We identify non-linear forms (both convex and concave regions) in the pay-off of MID, and discuss the implications for optimal mortgage purchase decisions. The model provides insights regarding the relationship between the effective MID and a set of underlying variables, including income level, house price, mortgage size, and state and local tax rates. In particular, we show how the tax shield value of a mortgage loan changes with key variables such as the life of the loan and the volatility of underlying processes. We apply the model to the case of optimal choice of adjustable versus fixed rate mortgages and prove that under a mean-preserving interest rate, an adjustable mortgage always offers a bigger tax saving. Our work demonstrates a novel aspect of dynamic analysis in the mortgage market.

A Dynamic Relationship between Crude Oil and Refined Products Prices

This paper examines the dynamics of the relationship between the prices of crude oil and of refined products. Theory insinuates some kind of dynamic equilibrium to govern these relations but we suspect that this equilibrium condition may be subject to changes over time. In Brent-based spreads between refined products and crude oil, no time trend is discernible. Decomposing the spread to fixed and variable cost components, however, reveals a steady tendency toward a larger intercept and a smaller elasticity parameter. We subject the stability of the assumed cointegrating relations of crude/refined pairs to three different statistical procedures. Applying the first two of them, the Gregory-Hansen test and the Kejriwal-Perron procedure, reveals at least one break point in each crude/refined pair. The timing of most breakpoints matches major turns and historical incidents in the global energy markets. The third approach assumes two or three discrete unobserved states that are treated as first-order Markov processes, with time-constant probabilities of switches between states. We offer several economic conjectures that may explain the observed patterns. The findings suggest that applied econometric estimations in this domain should give a higher weight to more recent samples, rather than relying on a long time-series.

On Quota Violations of OPEC Members

Over the last decades quota violations have become a norm for OPEC countries. However, the academic literature on OPEC focuses more on its production behavior than on analyzing the quota allocation process or characterizing quota violation patterns. This paper covers a theoretical model with empirical evidence to explain OPEC members’ incentives for abiding or violating quotas. We first cover a cartel model with a quota allocation rule and an endogenous capacity choice. The model highlights the trade-off between building spare capacity to bargain for a higher legitimate quota versus risking quota violation punishment. Using the quarterly data from 1995 to 2007, we empirically support the main results and intuitions for the model. Our empirical evidence is consistent with a theoretical framing in which capacity constraints work as an enforcement mechanism in good times and OPEC’s quota system disciplining its members in bad times.

Biofuel Producers in a Deregulated Market

In the deregulated fuels market, biofuels and fossil fuels are close competitors and substitutes. Thus, biofuel producers are subject to risks due to volatile crude oil and biofuels feedstock prices. This paper proposes a two-sector fuel market with competing oil refinery and biofuel sectors, calibrated for cases of gasoline/ethanol and diesel/biodiesel. The model suggests that ethanol and biodiesel plants will shut-down approximately 40% and 20% of the time, respectively. The skewness of profits is -0.32, in contrast to the 0.91 of feedstock prices. Several firm-level and policy-level options to manage crude oil price risks for biofuel producers are discussed further.

Chain of Cointegration in the Refined Products Market: From Crude Oil Spot to Gasoline Futures

Using multiple econometrics methods, this paper examines the cointegration and causality relationships between the futures prices of gasoline and the spot prices of two major types of crude oil (i.e. WTI and Brent). The existence of cointegration between prices in adjacent markets, crude oil spot and gasoline spot as well as gasoline spot and gasoline futures, has been shown by the previous research. Our research extends the literature by scrutinizing the transitivity property of cointegration in the chain of crude oil spot, gasoline spot, and gasoline futures markets. Among other results, we observe a bi-directional short-term causality between crude oil and gasoline prices. However, we only find a uni-directional long-run causality from gasoline futures contracts to crude oil spot prices (and not vice versa). Consistent with the latter, the impulse responses of gasoline futures prices to crude oil spot shocks are decaying; whereas, the response of spot prices to shocks to all gasoline futures prices is persistent. We also report some distinctions between the estimated cointegration vectors for WTI and Brent crude oil types.