Oil prices: risks and opportunities

Francesco Lippi, 11 June 2008

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Recent research by Jim Hamilton shows that the correlation between the price of oil and US production is unstable; it was negative and high in the 1970s but much smaller in more recent years.1 Nevertheless, the recent surge in oil prices gives rise to worries in Western economies – memories of the recessions of the ‘70s and early ‘80s are still vivid.
Can the 1970s be compared to the current situation? What hypothesis justifies a comparison, and what do the data say about it?

Supply and demand in theory, demand in practice

Most analysts attribute the increase in the price of crude oil to growing demand from Asian economies. Economic theory suggests that the real effect of an oil price increase depends on its underlying fundamentals. If it stems from a change in supply conditions – as was the case with the Iranian revolution, the first Gulf war, or policy tightening by OPEC – the resulting price increase depresses economic activity, as energy inputs are more expensive. But if higher oil prices stem from increased demand by emerging economies, production in other economies like the US is subject to both a negative effect – due to the higher price of energy – and to a positive effect – greater demand for US goods and services by the growing emerging economies. According to this scheme, the weak relationship between oil prices and the US business cycle in recent years reflects oil demand shocks, while the episodes in the ‘70s and ‘80s can be ascribed to oil supply shocks.

In a recent paper I co-authored with Andrea Nobili, we explore the roles of oil demand and supply shocks in US industrial production over the 1973-2007 period.2 Our study identifies the oil demand and supply shocks underlying fluctuations in oil prices (deflated by the US CPI). This allows us to estimate the effects of these shocks on the US business cycle. The identification strategy assumes that oil production and price move in opposite directions following a supply shock, while they move in the same direction following a demand shock.3 The analysis focuses on the real effects of the shocks, disregarding the inflation effect, which depends to a large extent on monetary policy.

What explains oil price fluctuations?

Our analysis shows that oil supply shocks account for less than half of oil price fluctuations over the last 30 years. More than half are due to oil demand shocks. A historical decomposition of the oil price time series, in Figure 1, shows that demand shocks emerge as a main cause underlying the current increase.

Figure 1 Historical decomposition of oil price (CPI deflated)


Note: The thin line denotes the price of oil (deflated by the US CPI) in both panels, in deviation from the baseline. The black bars denote the component of the series accounted for by respectively supply (left panel) and demand (right panel) shocks.

What are the effects of oil shocks?

The effects of oil demand and supply shocks on the US economy are markedly different. The left panel of Figure 2 shows that after a negative oil supply shock (that reduces production and increases the oil price), US industrial production falls (from the baseline trend) with an estimated probability of about 80% one year after the shock (the red line denotes the median response). After an oil demand shock causing a comparable increase in the price of oil, industrial production increases with an estimated probability of about 70% one year after the shock (see the right panel of Figure 2). Despite the “negative” production effect stemming from the higher oil price, the booming emerging economies ultimately lead to an increase in US industrial production the majority of the time.

Figure 2 Response of US production to oil mkt shocks


Note: US industrial production. The figure reports the 16th, 50th and 85th percentiles of the impulse response function distribution.

Risks and opportunities

The emergence of new players in the global economy makes some resources scarcer, increasing their cost, but it also offers new trade opportunities. The positive correlation between the price of oil and US industrial production shows that the US economy enjoys a net output gain from these developments. Our study suggests that America’s specialisation in the production of goods not supplied by emerging economies is key to this result. It is the ability – or lack thereof – to innovate and produce goods that are not easily substitutable that determines whether the new challengers represent a risk or an opportunity for industrialised countries.

This column originally appeared on 20 May 2008 in Italian on our Consortium partner’s site La Voce.

 


 

Footnotes

1 See Jim Hamilton “Oil and the Macroeconomy”, in The New Palgrave Dictionary of Economics, 2008. Second Edition. S. Durlauf and L. Blume (Eds), Palgrave MacMillan Ltd.
2Oil and the macroeconomy: a structural VAR analysis with sign restrictions”, di F. Lippi e A. Nobili.
3 The identification of the shocks uses sign restrictions to orthogonalise the innovations of a Vector Auto Regression (see Section 3 of the paper for more information).

 

 

Topics: Energy
Tags: Crude oil, oil price shocks, oil prices, oil shocks

Professor of Economics, University of Sassari and CEPR Research Fellow.