Theory of Oil Shocks

With oil on a tear higher, it pays to check out the academic world just to see what they have to say about it.  Here is a link to a paper by the left leaning Brookings Institution.

There are some interesting facts to glean out of this.  One, they found that the price of oil (gasoline) is not the primary determinant of short run demand.  Personal income is.  Oil consumption tracks personal income growth.

In each of the last five oil shocks in the Middle East; 1956 Suez Canal incident, 1973 Yom Kippur War, Iran fall of 1978, Iraq invasion of Iran 1980, and Iraq invasion of Kuwait 1990, countries that were able picked up production and filled in gaps from countries that could not produce oil.  It is reasonable to believe that the same outcome will occur in the present situation with Libya being off line.

When US inventories of crude are examined, the drawdown of inventory happened as prices were reaching their highs.  The researchers suggest that existing inventories eased the shock of higher oil prices.  Many people see the lower inventory as a cause of higher price.

Then they turn their attention to the shock of 2007-08 and the role of speculation.  Michael Masters has made the claim that the large commodity funds that are “buy only” distort the market.  Using a lot of math that you can see in the paper, they disprove Master’s claim.  The essential reason is the miscalculation of the elasticity of demand and changing consumer sentiment.  Masters claim is thoroughly debunked.

They do allow that Federal Reserve policy may have contributed to the rise in the price of oil, however they are very careful to show that the rise in the price of oil was almost purely explained by production that didn’t increase, and increased demand in the developing world.

It’s a very good paper and worth taking the time to read, even if you don’t understand the niceties of the math.

Read more at Points and Figures