The Role of Time‐varying Price Elasticities in Accounting for Volatility Changes in the Crude Oil Market

Abstract

SUMMARY There has been a systematic increase in the volatility of the real price of crude oil since 1986, followed by a decline in the volatility of oil production since the early 1990s. We explore reasons for this evolution. We show that a likely explanation of this empirical fact is that both the short‐run price elasticities of oil demand and of oil supply have declined considerably since the second half of the 1980s. This implies that small disturbances on either side of the oil market can generate large price responses without large quantity movements, which helps explain the latest run‐up and subsequent collapse in the price of oil. Our analysis suggests that the variability of oil demand and supply shocks actually has decreased in the more recent past, preventing even larger oil price fluctuations than observed in the data. Copyright © 2012 John Wiley & Sons, Ltd.

What Drives Long-term Oil Market Volatility? Fundamentals versus Speculation

“…First, compared with the US price of domestic crude oil (WTI oil price), which was regulated during the 1980s, the RAC for imported crude oil is likely to be a better proxy for the price of oil in global markets. Supportive evidence can be found in Kilian (2009), Alhajji and Huettner (2000), Baumeister and Peersman (2013), and many others. Second, because the process to construct the oil shocks is based on the work of Kilian (2009) Effects of oil shocks on the long-/short-term volatilities of oil prices…”

“…A change in the demand for commodities from emerging economies shifts world economic activity, oil prices and oil production in the same direction. This strategy has also been widely used in Van Robays (2009, 2012), Baumeister and Peersman (2013) and Kilian and Murphy (2014).…”

“…To test the robustness of the results, the sign restrictions are also imposed to hold for the first three months (see Paustian, 2007) and for the first six months (Barsky and Kilian, 2004) after the occurrence of the shocks, which accounts for the delayed response of the oil market variables in the early period of our sample due to institutional arrangements. These restrictions have been widely applied by Van Robays (2009, 2012), Kilian and Murphy (2012) and Baumeister and Peersman (2013). …”

“…We employ daily data for the period from January 1988 to the end of year 2015.The log-returns of crude oil are displayed in Figure 1.Our measure of global real economic activity is the updated version of the index of global real economic activity in industrial commodity markets, as proposed in Kilian (2009), i.e., the monthly percent deviations from the trend for 1990.1 to 2014.12.The real price of oil is defined as the US refiners' acquisition cost for imported crude oil, as reported by the EIA. 5 The refiners' acquisition cost for imported crude oil has been argued to be a better proxy for the price of oil in global markets than the US price of domestic crude oil, which was regulated during the 1970s and early 1980s 6 (Kilian, 2009) and has been used in the work of Baumeister and Kilian (2012), Peersman and Van Robays (2012) and Baumeister and Peersman (2013). With regard to data on crude oil inventories, we follow Hamilton (2009) and Kilian andMurphy (2012, 2014) and use the data for total US crude oil inventories provided by the EIA due to the lack of data for other countries.…”

“…Since this contribution, an impressive list of empirical studies has investigated the effects of different types of oil shocks and supports Kilian's (2009) conclusion. See, among others, Lütkepohl and NetŠunajev (2014), Kilian and Murphy (2014), Baumeister and Peersman (2013), Kilian and Park (2009), Lombardi and Van Robays (2011) and Van Robays (2009, 2012). Because of the importance of global demand in driving oil volatility, Aastveit et al (2014) take a further step to explicitly analyze the contribution of the demand of different geographical regions.…”