Oil prices: Risks and Opportunities

Most analysts attribute the increase in the price of crude oil to the demand by the Asian economies. These high prices spread worries on the Western economies, where the memory of the recessions in the 70s and early 80s, after similar spikes in oil prices, is still vivid.

Can these historical episodes be compared? What hypothesis justifies a comparison, and what do the data say about it?

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 Iran revolution, the Kuwait war, or policy tightening by Opec– the resulting price increase depresses economic activity in e.g. the US, as the energy input is more expensive. But if higher oil prices stem from increased demand by the emerging economies, production in the US is subject to a negative effect –due to the higher price of energy– and to a positive effect: the purchases of 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.1

We have explored the role of oil demand and supply shocks in a recent paper, focusing on the US industrial production over the 1973-2007 period2. Our study identifies the oil demand and supply shocks underlying the fluctuations of 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 shock3. The analysis focuses on the real effects of the shocks, disregarding the inflation effect that depends, to a large extent, on the monetary policy.

What explains oil price fluctuations?

The analysis shows that oil-supply shocks account for less than half of the oil-price fluctuations over the last 30 years. More than half is 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.


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), the 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). Instead, 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 production of the emerging economies ultimately leads to an increase of the US industrial production (as mentioned, in 70% of the estimated models). image002_11.jpg

Risks and opportunities

The emergence of new players in the global economy makes some resources more scarce, increasing their cost, but also offers new trade opportunities. The positive correlation between the oil price and the industrial production shows that the US economy gets a net output gain form these developments. Our study suggests that a key ingredient that ensures this result is the specialization of the US economy in the production of goods whose demand is not discarded by the supplies of the emerging countries. It is the ability to innovate and produce goods that are not easily substitutable that determines whether the new challengers represent a risk or an opportunity for the industrialized countries.

[1] For evidence on the time-varying correlation between the oil price and US production 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.

[2] “Oil and the macroeconomy: a structural VAR analysis with sign restrictions”, di F. Lippi e A. Nobili, downloadable at http://francescolippi.googlepages.com/research3 .

[3] The identification of the shocks is based on the orthogonalization of the innovations of a Vector Auto Regression with 4 variables, using sign restrictions (see Section 3 of the paper for more information).

4 Responses to "Oil prices: Risks and Opportunities"

  1. akmi   May 27, 2008 at 4:47 pm

    My guess is that most US industrial goods desired by emerging countries are capital goods rather than consumer goods. Unless, by industrial production, you include the agricultural industry as well?

  2. Guest   May 27, 2008 at 5:16 pm

    Does the size of shock have an effect on US output? What if the shock is so great that oil-led inflation erodes the output gain? The US might make more widgets but if widget prices or wages don’t rise along with inflation, won’t the output value fall even if volume rises?

  3. lakshmi   May 27, 2008 at 5:24 pm

    Guest, if production increases, that could mean more jobs created or, if there’s no job growth, then higher productivity – which supports the case for higher wages. If the current oil shock really is a demand-shock, the US economy should recover after the credit crisis ends.

  4. DANIELE   May 28, 2008 at 5:25 am

    IEA monthly reports confirm figure 1 data. It’s a long time that daily oil production lacks of thousands of barrels.In this condition it’s obvious to have an increase in oil price.About figure 2.Very interesting but I’m afraid that, this time, industrial production recovery could be strongly affected by "credit crunch" crisis.In my opinion, the more credit system is in "good shape" the more industrial recovery is fast.This time credit system is in a mess.ciaoDaniele