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Understand Oil Prices - Hamilton

Understand Oil Prices - Hamilton

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Understanding Crude Oil Prices*
James D. Hamilton jhamilton@ucsd.eduDepartment of EconomicsUniversity of California, San DiegoMay 22, 2008Revised: December 6, 2008ABSTRACTThis paper examines the factors responsible for changes in crude oil prices. The paperreviews the statistical behavior of oil prices, relates these to the predictions of theory, andlooks in detail at key features of petroleum demand and supply. Topics discussed includethe role of commodity speculation, OPEC, and resource depletion. The paper concludesthat although scarcity rent made a negligible contribution to the price of oil in 1997, it couldnow begin to play a role.*I thank Severin Borenstein, Menzie Chinn, Lutz Kilian, David Reifen, James Smith,and four anonymous referees for helpful comments on earlier drafts.
 
1 Introduction.
How would one go about explaining changes in oil prices? This paper explores three broadways one might approach this. The
rst is a statistical investigation of the basic correlationsin the historical data. The second is to look at the predictions of economic theory as tohow oil prices should behave over time. The third is to examine in detail the fundamentaldeterminants and prospects for demand and supply. Reconciling the conclusions drawn fromthese di
ff 
erent perspectives is an interesting intellectual challenge, and necessary if we areto claim to understand what is going on.In terms of statistical regularities, the paper notes that changes in the real price of oilhave historically tended to be (1) permanent, (2) di
cult to predict, and (3) governed byvery di
ff 
erent regimes at di
ff 
erent points in time.From the perspective of economic theory, we review three separate restrictions on thetime path of crude oil prices that should all hold in equilibrium. The
rst of these arises fromstorage arbitrage, the second from
nancial futures contracts, and the third from the factthat oil is a depletable resource. We also discuss the role of commodity futures speculation.In terms of the determinants of demand, we note that the price elasticity of demandis challenging to measure but appears to be quite low and to have decreased in the mostrecent data. Income elasticity is easier to estimate, and is near unity for countries in anearly stage of development but substantially less than one in recent U.S. data. On thesupply side, we note problems with interpreting OPEC as a traditional cartel and withcataloging intermediate-term supply prospects despite the very long development lead times1
 
in the industry. We also relate the challenge of depletion to the past and possible futuregeographic distribution of production.Our overall conclusion is that the low price-elasticity of short-run demand and supply,the vulnerability of supplies to disruptions, and the peak in U.S. oil production account forthe broad behavior of oil prices over 1970-1997. Although the traditional economic theoryof exhaustible resources does not
t in an obvious way into this historical account, theprofound change in demand coming from the newly industrialized countries and recognitionof the
niteness of this resource o
ff 
ers a plausible explanation for more recent developments.In other words, the scarcity rent may have been negligible for previous generations but maynow be becoming relevant.
2 Statistical predictability.
Let
p
t
denote 100 times the natural log of the real oil price in Figure 1 as of the third monthof quarter
t
and let
 p
t
denote the quarterly percentage change. The average value of 
 p
t
over 1970:Q1-2008:Q1 is 1.12. The
t
statistic for that average growth estimate is 0.91, failingto reject the hypothesis that the expected oil price change could be zero or even negative.One can also explore simple forecasting regressions of the form
 p
t
=
β
0
x
t
1
+
ε
t
(1)where
x
t
1
is a vector of variables known the quarter prior to
t
that might have helped predictthe oil price change in quarter
t
. Table 1 reports the results of testing for such predictability2

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