By Alejandro Badel, Economist, and Joseph McGillicuddy, Research Analyst
Oil prices have dropped more than 50 percent since mid-2014. Establishing whether demand or supply factors lie behind this slump is possibly useful for understanding its potential impact on the economy.
We set out to replicate a leading statistical decomposition of the factors affecting oil prices found in the economics literature. We followed the methodology in Lutz Kilian’s 2009 paper “Not All Oil Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market,” a prominent empirical paper about oil prices and macroeconomic variables.1
The model used in the paper consists of a three-variable monthly frequency structural vector auto-regression. The three variables included are:
Then, three structural shocks are identified using the following assumptions (exclusion restrictions):
The figures below show the results obtained from using code provided by the author after updating his dataset.
Note: World crude oil production for the period January 1973 through September 2014 is from the U.S. Energy Information Administration (EIA). We impute the October and November 2014 data points using total oil production data from the International Energy Agency’s Oil Market Reports. The updated index of real economic activity for the period January 1973 through October 2014 is from http://www-personal.umich.edu/~lkilian/reaupdate.txt. We impute the November 2014 point using the HARPEX index. It should be noted that changing the growth rate of the index by one standard deviation in either direction for November 2014 does not visibly affect the figure. The monthly nominal oil prices for the period January 1974 through November 2014 are from the EIA, while 1973 values are from the Kilian (2009) series.
The figures tell the following story:
1 Kilian, Lutz. "Not All Oil Price Shocks Are Alike: Disentangling Demand and Supply Shocks in the Crude Oil Market." American Economic Review, June 2009, 99(3), pp. 1053-69.