Factors other than changes in oil supply may cause changes in oil prices.Petroleum products - Prices

Kristie M. Engemann

Michael T. Owyang

English

Research Papers in Economics

Economic SYNOPSES
short essays and reports on the economic issues of the day
2010 ■ Number 9
A
widely popular notion is that oil price fluctuations
are primarily driven by changes in oil supply. This
belief may have formed because much of the pro-
duction of oil is determined by a cartel (the Organization
of the Petroleum Exporting Countries). During the 1970s
and early 1980s, several oil supply disruptions were associ-
ated with large increases in the real price of oil. In particu-
lar, the oil embargo of 1973 and the Iranian Revolution of
1979 appeared to cause large increases in oil prices.
The chart tracks the West Texas Intermediate crude oil
spot price (deflated by the headline consumer price index)
and world crude oil production. For both series, the rate
of change in the two-quarter moving average is shown.
The vertical bars represent the noted historical periods
and a few others that seemingly affected oil prices—the
start of the Iran-Iraq War in 1980, the start of the Persian
Gulf War in 1990, civil unrest in Venezuela in 2002, and
the invasion of Iraq in 2003. 
As the chart shows, oil price changes do not always react
in the opposite direction of supply changes, implying that
additional factors may be at work.
Economist Lutz Kilian (2009) recently
studied three different types of oil price
shocks: changes in (i) production
(i.e., supply shocks), (ii) global demand
driven by economic activity, and (iii)
precautionary demand, which is the
demand for assets (in this case, oil)
to guard against future emergencies
(e.g., unanticipated shortages).1
Similar to conventional increases in
demand (say, for production or trans-
portation), increases in precautionary
demand raise the price of oil.
If different oil price shocks occur
around the same time, can we differ-
entiate their effects on oil prices? Kilian
addresses this question in the context
of some notable oil price spikes. For
instance, he finds that the price increases in 1979-80 were
primarily caused by increases in precautionary demand,
while oil production declines had a relatively small impact.
The same can be said for the Persian Gulf War period.
Since 2002, however, most of the price increases can be
attributed to increased global demand from countries such
as China and India. Overall, Kilian’s results provide evidence
that increases in the demand for oil are the main contribu-
tors to fluctuations in the real price of oil.
This does not imply that disruptions in oil supply have
no effect. Changes in supply now can indirectly affect prices
by raising precautionary demand if agents believe that
Not Your Father’s Oil Shock
Kristie M. Engemann, Senior Research Associate
Michael T. Owyang, Research Officer and Economist
Factors other than 
changes in oil supply 
may cause 
changes in oil prices.
Changes in Moving Average of Oil Price and World Oil Production (Quarterly)
–60
0
60
1973 1977 1981 1985 1989 1993 1997 2001 2005 2009
–6
0
6
Price (left scale) Production (right scale)
Percent
SOURCE: Wall Street Journal and Bureau of Labor Statistics (West Texas Intermediate crude oil spot 
price deflated by consumer price index); U.S. Energy Information Administration (the monthly 
average of world crude production in thousands of barrels per day). The log rates of change for 
the two-quarter moving averages are shown. The text lists the events indicated by vertical bars. 
Percentfuture disruptions will escalate. If, say, political unrest in
oil-producing regions leads to uncertainty about future oil
supplies, precautionary demand will increase, as will oil
prices. ■
1 Kilian, Lutz. “Not All Oil Price Shocks Are Alike: Disentangling Demand and
Supply Shocks in the Crude Oil Market.” American Economic Review, June 2009,
99(3), pp. 1053-69.
Economic SYNOPSES Federal Reserve Bank of St. Louis      2
research.stlouisfed.org
Posted on April 15, 2010
Views expressed do not necessarily reflect official positions of the Federal Reserve System.

Not your father's oil shock

http://research.stlouisfed.org/publications/es/10/ES1009.pdf

Not your father's oil shock

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