It is commonly believed that disruptions in oil supplies played a major role in previous oil price shocks. Recent research, however, appears to suggest that other factors than supply disruptions have been key drivers of previous volatility in oil prices.
Economists have long ascribed major oil price shocks to oil supply disruptions triggered by exogenous political events in the Middle East, but over the last decade this consensus has been shattered. New research has shown that with rare exceptions oil supply shocks have had, at best, modest effects on the real price of oil and that all large and persistent swings in the real price of oil have been driven by fluctuations in global real economic activity. In addition, there is strong evidence that concerns about future supply shortfalls may cause speculative demand for oil to surge, resulting in potentially large shifts in the real price of oil.
To illustrate how economists’ views of oil price shocks have evolved, consider the first major oil price shock in recent history. In 1973–1974, the nominal price of oil quadrupled over the course of a few months. Many observers used to associate this oil price shock with the Arab oil embargo that followed the Yom Kippur War of October 1973. The presumption was that the embargo involved a disruption of Middle Eastern oil supplies. At first glance, the case for an oil supply shock looks strong: the data show an increase in the real price of oil along with a decline in the quantity of oil produced. In a free-market model, this pattern can only be caused by an exogenous decline in the supply of oil.
The problem is that the market for crude oil was not free in the early 1970s. Middle Eastern oil producers were subject to long-term contractual agreements with foreign oil companies that effectively prevented the real price of oil from rising, as the world economy expanded in the early 1970s, while allowing oil companies to extract more oil from the Middle East at that low price to satisfy the additional demand. In fact, while other industrial commodity prices surged in real terms in 1972 and early 1973, the real price of oil declined. When Middle Eastern oil producers broke these contractual agreements in late 1973 and expropriated the oil companies, these constraints were released. The real price of oil shot up and the quantity of oil produced fell toward the values that would have prevailed in a free market, which is exactly the pattern usually associated with an unexpected oil supply disruption.
Although there is no reason to believe that the Organization of the Petroleum Exporting Countries (OPEC) oil producers had any intention of restoring markets, there is surprisingly little evidence that OPEC used its new market power to impose excessively high prices. We can obtain a rough sense of how close the real price of oil in early 1974 came to market-clearing levels by comparing the cumulative rate of increase in the real price of oil during the period of economic expansion from November 1971 through February 1974 with the corresponding increase in the real price of metals or industrial raw materials, which were traded in free markets. This comparison suggests that about 75 percent of the increase in the real price of oil in 1973–74 would have been expected even in the absence of the oil embargo based solely on strong demand for oil driven by the global business cycle. This conclusion is further reinforced by the fact that, at best, 25 percent of the observed increase in the real price of oil in 1973–74 can be explained by exogenous oil supply shocks (and by some accounts much less), leaving the remaining 75 percent to be explained by demand shocks. In the absence of price ceilings in the oil market, the 1973–74 oil price surge would have appeared remarkably similar to the sustained surge in the real price of oil between 2003 and mid-2008.
The second major oil price shock occurred in 1979. It used to be common to associate the sustained increase in the real price of oil in late 1979 and early 1980 with the Iranian Revolution, but that explanation does not fit the data: although the Iranian Revolution was arguably an exogenous event, the oil supply disruptions triggered by this event occurred between December 1978 and February 1979. By April 1979, the new Iranian government was already resuming oil production. Yet, the real price of oil did not really begin to take off before May of that year. The surge continued into 1980 long after the Iranian supply problems were resolved and world oil production had expanded beyond pre-revolution levels. More recent research instead attributes this oil price shock to a combination of renewed strong demand driven by the global business cycle (much like in the early 1970s) and a surge in speculative demand after May 1979, driven by fears of a possible military conflict with Iran amidst a booming world economy.
It is important to bear in mind that not all oil price shocks are the same. In particular, swings in the global business cycle played a central role in creating the oil price shocks of the 1970s, but not the shocks of late 1980, of 1986, and of 1990–1991. For example, the outbreak of the Iran–Iraq War in late 1980 involved an exogenous oil supply disruption that had little effect on the real price of oil. The subsequent sharp drop in the real price of oil in 1986 owed as much to a sharp reduction in speculative demand for oil, following the collapse of OPEC in late 1985, as it did to an unexpected increase in Saudi oil production. Another clear example of an oil price shock not driven by global real activity is the sharp spike in the real price of oil in 1990–91, following Iraq’s invasion of Kuwait. That shock reflected a combination of an oil supply disruption caused by the invasion and a temporary surge in speculative demand as traders anticipated a broader war extending to Saudi Arabia.
In sharp contrast, several studies have shown that the sustained increase in the real price of oil between 2003 and mid-2008 was mainly caused by unexpected increases in global real economic activity, as was the more recent collapse and partial recovery of the real price of oil. Unlike the global economic expansions of the early and late 1970s (and the global economic recession of the early 1980s)—which were driven by worldwide shifts in monetary policy first toward a more inflationary regime in the early 1970s and then back to a conservative policy regime under Federal Reserve Chairman Paul Volcker in 1979—the global economic expansion of the 2000s was caused by strong unexpected growth in emerging Asia on top of solid economic growth in the Organisation for Economic Co-operation and Development (OECD). There is no evidence that the sustained oil price increase after 2003 was driven by speculation, not even in 2007–2008. In fact, the analysis of oil inventory data establishes that speculation cannot possibly explain the oil price fluctuations in recent years. Nor is there evidence that deliberate production cutbacks by OPEC oil producers contributed to the recent oil price surge or that the peak oil hypothesis applied.
The alternative view of oil price shocks suggested by recent research has strong policy implications. First, the real price of oil is expected to rise, as the global economy recovers from the financial crisis, creating a policy dilemma, unless energy consumption can be reduced or new energy sources can be found. Second, additional regulation of oil traders is unlikely to prevent the real price of oil from rising again in the future and indeed would have been ineffective during 2003–2008. Third, increased domestic oil production in the United States, as recently proposed, is not expected to have much of an effect on the real price of oil, given the small magnitude of the production increments involved when measured on a global scale.
Lutz Kilian is a professor of economics at the University of Michigan and a research fellow of the Centre for Economic Policy Research. His research interests span time series econometrics, empirical macroeconomics, international finance, and energy economics.
Kilian, L. 2008. The Economic Effects of Energy Price Shocks. Journal of Economic Literature 46(4): 871–909.
Kilian, L. 2010. Oil Price Shocks, Monetary Policy and Stagflation, in Inflation in an Era of Relative Price Shocks, edited by Fry, R., Jones, C., and C. Kent. Sydney, 60–84.
Kilian, L., and D. Murphy. 2010. The Role of Inventories in Identifying Oil Demand and Oil Supply Shocks. Unpublished, University of Michigan.