Structural VAR, ethanol, crude oil, gasoline, shocks, Agricultural and Food Policy, Environmental Economics and Policy, Q1, Q2, Q4,

McPhail, Lihong Lu

English

Research Papers in Economics

Assessing the impact of U.S. ethanol market shocks on global crude oil and U.S. 
gasoline: a structural VAR approach
By
Lihong Lu McPhail
Economic Research Service, USDA
Email: lihong.l.mcphail@gmail.com
Poster prepared for presentation at the Agricultural & Applied Economics 
Association 2010 AAEA, CAES, & WAEA Joint Annual Meeting, Denver, Colorado, July 
25-27, 2010
The views expressed are those of the author and should not be attributed to the 
Economic Research Service or the U.S. Department of Agriculture.Question
Does demand for alternative fuel such as ethanol partially explain 
the stagnation of global oil supply?
• Daniel Yergin of CERA wrote in Washington Post on July 31st, 2005
“Between 2004 and 2010, capacity to produce oil (not actual production) could grow by 16 million 
barrels a day— from 85 million barrels per day to 101 million barrels a day—a 20 percent 
increase. “
• Couple this expanding abundance of crude oil with the world's increasing demand for 
transportation fuels from 2005 to 2008 and one would expect to see an increase in crude oil 
supply. However, crude oil supply was stagnant from 2005 to 2008. 
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U.S. Ethanol Production (Thousand Barrels Per Month)
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World Oil Supply (Thousand Barrels Per Day)
Source: Energy Information Administration (EIA)Goals and approach
• To examine the responses of prices and quantities of 
global crude oil and U.S. gasoline markets to policy-
led ethanol production
• By constructing a structural VAR model of global oil 
market, U.S. gasoline market, and U.S. ethanol 
marketStructural VAR
0
1
p
t t i t i
i
A x A x a e -
=
= + + ∑
• Growth rate of global oil production 
• Real global economic activity
• Real crude oil price 
• Real U.S. gasoline price
• Growth rate of U.S. gasoline consumption
• Real U.S. ethanol price 
• Level change in U.S. ethanol production 
t
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t t
t
t
t
prodo
rea
rpo
x rpg
consg
rpe
prode
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 
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  = 
  D
 
 
  D  What are the shocks?
oil supply shock
aggregate demand shock
oil specific-demand shock
gasoline supply shock
gasoline demand shock
ethanol demand shock
ethanol supply shock
t
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=
Examples of causes of different shocks: 
• Iraq war 2003
• Emergence of industrial economy in Asia
• Oil demand increase before Iraq war 2003
• Refinery shutdown caused by hurricane
• Urbanization
• A change in policy, such as RFS
• Feedstock price increase caused by weatherIdentifying assumptions
11
21 22
31 32 33
41 42 43 44
55 51 52 53 54
61 62 63 64 65 66
75 77 71 72 73 74 76
0 0 0 0 0 0
0 0 0 0 0
0 0 0 0
0 0 0
0 0
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prodo
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consg
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e a
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a a a a a a e
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   
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         
º =
oil supply shock
aggregate demand shock
oil specific-demand shock
gasoline supply shock
gasoline demand shock
ethanol demand shock
ethanol supply shock
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Perfectly inelastic oil 
supply
Perfectly elastic 
gasoline supply Perfectly elastic 
ethanol demandCrude Oil
Ethanol
Gasoline
Poil
Pgas
Peth
DCrude
SCrude
DEthanol
Poil =>
DGas 
SGas
=
>
Poil
Demand for ethanol is determined 
by the price of gasoline. 
SEthanol
Gasoline demand is 
assumed to never 
exceed total gasoline 
reserves in one 
month.  Thus, elastic 
supply of gasoline.
Crude oil supply is assumed to react slowly (> 1 
month) to aggregate demand. – Daniel Yergin Data: the global economic activity index
• Killian shows that oil supply shock alone do not explain the bulk of oil 
price fluctuations
• Killian proposes to the use of freight rates, such as Baltic dry Index, to 
capture shifts in the demand for industrial commodities driven by the 
global business cycle. 
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Real Baltic Dry Index
WHY?
Freight Shipping
Q 
D
S
PData: prices
Source for norminal ethanol prices: http://www.neo.ne.gov/statshtml/66.html
Source for gasoline and crude oil prices: EIAData: US gasoline consumption
Source: Energy Information Administration
Seasonal variation is removed and then the data are transformed to the growth 
rate of U.S. gasoline consumptionFindings
• The growth rate of global oil production does respond to an 
ethanol demand shock with statistical significance, but not 
a supply shock. 
￿ Ethanol demand is mainly driven by policy. A change in ethanol 
demand is a change in policy. Ethanol supply shock is caused by 
an unanticipated change in feedstock prices, largely driven by 
weather conditions. This suggests that oil producers respond more 
to the largest government voting for support for alternative fuel than 
the passing weather.
￿ Ethanol could affect crude oil market, not because it is currently a 
competitor as it accounts for less than 1% flowing into the crude oil 
market; but because when US government votes on the value of 
renewable energy; that will affect the future of fossil fuel.Findings 
• We do not find a statistically significant impact of shocks 
to ethanol markets on crude oil prices. 
• Ethanol demand and supply increases cause statistically 
significant drops in real gasoline prices, but do not affect 
the growth rate of gasoline consumption.References
• Killian, L.. 2010. "Explaining Fluctuations in Gasoline Prices: A Joint 
Model of the Global Crude Oil Market and the U.S. Retail Gasoline 
Market." forthcoming: Energy Journal, 31(2), 105-130.
• Killian, L.. 2009. "Not All Oil Price Shocks Are Alike: Disentangling 
Demand and Supply Shocks in the Crude Oil Market, " American 
Economic Review, 99, 1053-1069.
• Yergin, D.. 1992. "The Prize: the Epic Quest for Oil, Money and 
Power."Acknowledgement
Thanks to Joseph McPhail, Dr. Bruce Babcock, Dr. James Bushnell,
Dr. Sergio Lence, Dr. David Hennessy, and Dr. Peter Orazem 
for their expert feedback. 

Assessing the impact of U.S. ethanol market shocks on global crude oil and U.S. gasoline: A structural VAR approach

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