RESEARCH AND ANALYSIS
Oil Price Volatility: Origins and Effects
Lutz Kilian, Professor of Economics at the University of Michigan and CEPR.
In recent years, our understanding of the nature of energy price shocks and their effects on the economy has evolved dramatically. Only a few years ago, the prevailing view in the literature was that at least the major crude oil prices increases were exogenous with respect to the OECD economies and that these increases were caused by oil supply disruptions triggered by political disturbances in the Middle East. This view has little empirical support. Likewise, the popular notion that OPEC constitutes a cartel that controls the price of oil has not held up to scrutiny. At the same time, there has been increasing recognition of the importance of shifts in the demand for oil. Recent research has provided robust evidence that oil demand shocks played a central role in all major oil price shock episodes since the 1970s.
There is no consensus in the literature on how to model the global market for crude oil. One strand of the literature views oil as an asset, the price of which is determined by desired stocks. In this interpretation, shifts in the expectations of forward-looking traders are reflected in changes in the real price of oil and changes in oil inventories. The other strand of the literature views the price of oil as being determined by shocks to the flow supply of oil and flow demand for oil with little attention to the role of inventories in smoothing oil consumption.
Recent research shows that shocks to the flow supply of crude oil overall have had little impact on the real price of oil since 1973. In contrast, shocks to the flow demand for oil associated with the global business cycle have been responsible for long swings in the real price of oil, notably in 1973/74, 1979/80 and 2003-2008. In addition, speculative demand shocks defined as any demand shock that reflects forward looking behavior by traders played an important role in 1979 (following the Iranian Revolution), in 1986 (following the collapse of OPEC), in 1990/91 (following the invasion of Kuwait), in 1997-2000 (following the Asian crisis) and in late 2008 (during the global financial crisis). Unlike shocks to the flow demand or flow supply, speculative demand shocks can cause large immediate effects on the real price of oil, for example in response to geopolitical events.
Although speculative trading appears to have played an important role in some historical episodes, there is no evidence that it caused the surge in the real price of oil during 2003-06 and only very limited evidence that it helps explain the 2007-08 oil price surge. Instead, the bulk of the 2003-08 increase in the real price of oil was caused by fluctuations in the global business cycle, driven in large part by unexpected growth in emerging Asia superimposed on strong growth in the OECD. As the world economy collapsed in late 2008, so did the real price of oil. More than half of the observed decline in the real price of oil, however, was driven by expectations about a prolonged global recession. The gradual recovery of the real price of oil in 2009 can be attributed equally to a partial reversal of these expectations and to a recovery of the demand for industrial commodities, reflecting the improved state of the global economy.
The distinction between different oil demand and oil supply shocks has far-reaching implications because each shock has different effects on the U.S. economy and on the real price of oil. In addition, not all such shocks are unambiguously harmful to oil importing economies. For example, shocks to the global flow demand for oil have both a stimulating effect on the U.S. economy and adverse effects on economic growth working through higher oil prices in particular and higher industrial commodity prices more generally. Empirical estimates suggest that, in the short run, the positive effects on the U.S. economy are strong enough to sustain growth, while global commodity prices are slow to respond and the world economy is booming. Only subsequently U.S. real GDP gradually declines, as commodity price increases gain momentum and the economic stimulus from higher global demand weakens. This response pattern differs sharply from the typical effect of higher energy prices driven by shocks to the speculative demand for crude oil, for example, or by shocks to the flow supply of crude oil, but it helps explain why the 2003-08 surge in the real price of oil did not create a major recession long before the global financial crisis.
One direct implication of recent models of the endogenous determination of the real price of oil is that conventional estimates of the response to unanticipated oil price changes are best thought of as the response to an average oil price shock and in practice may be sensitive to the sample period, as the composition of the underlying demand and supply shocks evolves over time. This helps understand why regressions of macroeconomic aggregates on oil prices tend to be unstable over time and in particular why the average effect of oil price shocks appears to have diminished since the late 1980s.
A second implication is that it is not logically possible to attribute the macroeconomic effects associated with an oil price shock to the observed change in the real price of oil. This would be misleading because the ceteris paribus assumption is violated. It is more appropriate to think of oil price fluctuations as symptoms of the underlying oil demand and oil supply shocks. This calls for a fundamental change in the way policymakers and economists think about the relationship between oil price volatility and economic outcomes. For example, one cannot assess the causal effects of the oil price increase of 2003-08 on the global economy because much of that oil price increase was caused by strong growth in the global demand for industrial commodities in the first place. In contrast, a better-posed question would be how the growth in emerging Asia has affected the economic performance of OECD economies both directly through trade and financial asset market channels and indirectly through rising commodity prices.
Third, standard theoretical models of the transmission of oil price shocks that maintain that everything else remains fixed, as the real price of imported crude oil increases, are misleading and must be replaced by models that allow for the endogenous determination of the price of oil rather At this point we are only beginning to understand the theoretical implications of endogenizing the real price of oil.