Causes of the Oil Shock of 2007-08

I will be presenting my latest research paper, Causes and Consequences of the Oil Shock of 2007-08, at a conference today at the Brookings Institution. Here I review some results from that paper about what caused oil prices to rise so spectacularly in 2007-08 only to decline even more dramatically afterward.

World real GDP increased by 9.4% between 2003 and 2005. That growth in world income was the primary cause behind an increase in world petroleum consumption of 5 million barrels per day between 2003 and 2005, a 6% increase over the two years. The next two years (2006 and 2007) saw even faster economic growth (10.1% cumulative two-year growth), with Chinese oil consumption alone increasing 870,000 barrels per day. Yet between 2005 and 2007, global oil production stagnated.



Thin line. Monthly global crude oil production, including lease condensate, natural gas plant liquids, other liquids, and refinery processing gain, in millions of barrels per day, 2003:M1-2008:M10. Data source: EIA. Bold line: 12-month moving average of values from thin line centered at indicated date..
oil_supply_apr_09.gif



What persuaded residents outside of China to reduce petroleum consumption in the face of booming levels of income? The answer is that the price of oil had to increase. How much the price should have risen depends on the price elasticity of demand. Consider the following illustrative calculations. It seems reasonable to maintain that the economic growth in 2006 and 2007 would have resulted in at least as big a shift of the demand curve as resulted from the slightly weaker GDP growth of 2004 and 2005. Adding in the first half of 2008 (when global GDP continued to rise), consider then the consequences of a rightward shift of the demand curve of 5.5 million barrels per day. With production only increasing by 0.5 mb/d over this period, a demand elasticity of ε = 0.06 would imply that the price should have risen from $55/barrel in 2005 to $142/barrel in 2008:H1.




bpea1.gif





Illustrative price effects of 5.5 mb/d rightward shift of demand curve and 0.5 mb/d rightward shift of supply curve between 2005 and 2008:H1 assuming price elasticity of 0.06. Source: Hamilton (2009).
bpea2.gif



A short-run elasticity of 0.06 for crude petroleum demand could certainly be defended on the basis of estimates in the literature, though so could a higher or lower value. I offer the above calculation simply as an illustration that the observed price behavior could be fully reconciled with reasonable assumptions about supply and demand.

But why then did the price subsequently collapse even more dramatically? A shift of the demand curve back to the left as a result of the impressive global economic downturn is certainly part of the answer. Note, however, that even if global real GDP were to fall by more than 10%– which so far fortunately it has not– that would only put us back to where we were in 2005 (at $55 a barrel), and the price was observed to fall even more than this. We therefore would need to postulate a second factor behind the price decline of 2008:H2, namely, an increase in the price elasticity of demand as consumers had time to make adjustments. Again such a hypothesis is consistent with previous experience, and in particular, between 2007:Q3 and 2008:Q3, U.S. petroleum consumption fell by 8.8%. That drop in U.S. petroleum consumption unambiguously represented the combined effects of lower income and price-induced changes in use.

If we say that one elasticity (0.06) is to be used to account for the 2008:H1 price and another higher elasticity for 2008:H2, there is an implicit claim that market participants were learning imperfectly about the price elasticity of demand. There was a surprisingly long period in which demand responded less than some might have expected to the oil price increases (i.e., consistent with an elasticity of 0.06), and then a very dramatic drop in oil use as a result of the combined influence of falling incomes and changing consumption habits.

My paper also has an extensive examination of an alternative explanation based on a speculative bubble in the price of oil. I will not attempt to reproduce much of that analysis here, but only note the bottom line: in order to reconcile a proposed speculative bubble story with the observed behavior of the physical quantities demanded, supplied, and going into inventories, it is necessary to postulate a very low price elasticity of demand through 2008:H1– precisely the same conditions one would need in order to attribute the price moves entirely to fundamentals.

In terms of policy implications, the paper suggests that sales out of the Strategic Petroleum Reserve could have been explored as a possible tool for curbing excessive speculation, and proposes that the U.S. Federal Reserve needs to take account of possible consequences of its actions for relative prices of commodities. My bottom line was nevertheless the following:

But while the question of the possible contribution of speculators and the Fed is a very interesting one, it should not distract us from the broader fact: some degree of significant oil price appreciation during 2007-08 was an inevitable consequence of booming demand and stagnant production. It is worth emphasizing that this is fundamentally a long-run problem, which has been resolved rather spectacularly for the time being by a collapse in the world economy. However, the economic collapse will hopefully prove to be a short-run cure for the problem of excess energy demand. If growth in the newly industrialized countries resumes at its former pace, it would not be too many more years before we find ourselves back in the kind of calculus that was the driving factor behind the problem in the first place. Policy-makers would be wise to focus on real options for addressing those long-run challenges, rather than blame what happened last year entirely on a market aberration.



Technorati Tags: ,
,

StumbleUponLinkedInReddit

48 thoughts on “Causes of the Oil Shock of 2007-08

  1. lilnev

    “there is an implicit claim that market participants were learning imperfectly about the price elasticity of demand.”
    I think I don’t understand this sentence. Isn’t it just a case of short-term elasticity being low and longer-term elasticity being higher? It’s very possible to end up in price overshoot in such situations. Or by “learning imperfectly” do you mean that were missed arbitrage opportunities to sell down inventories in the expectation that they could be replenished more cheaply later?

  2. DickF

    Good summary, Professor. It is good to see someone look at the fundamentals rather than simply having a knee jerk reaction and calling this a bubble.
    I hate it when someone criticizes a paper because of what it does not contain so do not take this as criticism. I do believe that your paper does cry out for continued analysis. Yes, production did stagnate, but, with such increased demand from the emerging economies, why?
    I know there are some who would have a knee jerk reaction and blame peak oil, but as you did with this paper, proper analysis would go deeper. I do not have data to back up my opinion, but from my discussions with those in the industry the primary reason seems to be that oil production infrastructure could not support the level of production demanded; scarcity driving up prices.
    I know that during the peak price periods Brazil was buying all the oil production and transportation material they could find. That seems to be an anecdote to point us not to a lack of resources but a lack of extraction, storage, and transportation.

  3. MikeR

    Great post, but I do not think it is the purpose of the SPR to damp naturally occurring oil price volatility, as from an increase in global GDP. Also, if we make oil prices less volatile, perhaps we would have less of a reason to conserve.
    The DOE website states:
    “Decisions to withdraw crude oil from the SPR are made by the President under the authorities of the Energy Policy and Conservation Act. In the event of an energy emergency, SPR oil would be distributed by competitive sale. The SPR has been used under these circumstances only twice (during Operation Desert Storm in 1991 and after Hurricane Katrina in 2005). Its formidable size (700-plus million barrels) makes it a significant deterrent to oil import cutoffs and a key tool of foreign policy.”

  4. spencer

    Did you attempt to calculate both a short run and a long run price elasticity?
    An alternative, or supplementary analysis of the collapse in oil prices would be that in 2008 the long run price elasticity finally came into play.
    This is not to knock your paper, it is very good.

  5. kharris

    I may unwittingly be about to make the “bubble” argument, but that is not my intention. Easy access to credit tens to change behavior in a number of ways. Could the slow shift in behavior you point out in noting that elasticity shifted slowly have been the result of easy credit reducing the need to adjust? We bought too many homes, too many financial instruments, too many stocks, in large part because we could get as much credit as we wanted to do these things. Petroleum may not be a compliment to stocks and derivatives, but it is certainly a compliment to suburban living, urban sprawl, and conspicuous consumption financed through mortgage equity withdrawal. At a distance, all that petroleum was also needed by the producers of the (imported) goods the US and UK and others consumed.
    In retrospect (I’m not smart enough for any other kind of thinking), it seems to me quite natural that demand for energy would go bonkers, because that fit in with everything else that was happening.
    The failure of supply to respond was another issue. There is no need to focus solely on peak oil, or to join in the pre-packaged dismissal of the peak-oil argument, in this discussion. The behavior of oil companies may be complex, but it is not unfathomable. Accumulation of of existing reserves was apparently preferred to discovery of new reserves, for whatever reason. The industry had also been through a prior episode of drastic price increases, and lost a bundle in responding to it through expanded exploration and oil field development. Certainly inventory manipulation and futures sale and purchase address prices in the short run, but it is decisions about production that determine the shape of the supply curve over longer periods.

  6. David

    Do you think the start of the run up in oil prices was related to the major’s writing down reserves? If memory serves me correctly, there was at least one of the major’s CEO who lost his job over this. I do not recall exact numbers but if a major writes down 10% of their reserves that would tighten up fundamentals.

  7. Marc V

    I agree with Mike R. with the SPR being used for “energy emergencies” and not as some hedge supply. When the hurricanes knocked out oil/fuel processing facilities in the Gulf of Mexico earlier this decade, the SPR was there and temporarily helped with supply. An unspoken purpose of the SPR is for military use, as our national defense hinges on petroleum fuel.
    The “long-run” challenges you mention at the end may unfortunately creep up to short-run very soon. With the double whammy of tight credit/poor economy (minimal profit) and a lack of large (and relatively easy extraction) oil fields to exploit, oil companies have not been investing in the exploration and development of new oil sources. You also have the steady decline of the large oil fields in the Mideast, the shrivelling up of Cantarrel in Mexico, and the other oil exporters using more of their own resource and exporting less. Any kind of global economic recovery will quickly run into the brick wall of no more cheap energy.

  8. Tim

    There really is no doubt that the 2007-2008 run up was aided by “investors” aka speculation. Just look at the SEC filings for the exchange-traded instruments that became available to retail investors (and small hedgies) in the last few years to see the huge swell in assets following a mechanical futures roll strategy.

  9. oops

    while i didn’t hear the interview that someone on tv quoted, the chief of france’s total said that he expects supply to be greater than demand until 2011.
    aside from the fact that supply will pretty much equal demand and that he is probably basing this on gdp growth that may or may not be correct it is still scary to think of $140 oil in two years or so.

  10. ndd

    It seems to me, you are missing the impact of “Hoarding in Plain Sight” by increases in the public US, and public and private Chinese strategic reserves; and also the effect of the reduction in Asian countries’ consumer subsidies in mid-2008.

  11. Tom

    Tim,
    Just look at that little seatbelt light next time you are on an airplane – every time the pilot turns it on, it causes the air to get turbulent.

  12. GNP

    Instead of sales out of the Strategic Petroleum Reserve wouldn’t simply stopping SPR purchases have helped? Philip Verlager, Jr. has suggested that buying light, high-grade crude for the SPR during H108 contributed to much higher prices. Though he appears to also favour counter-cyclical purchases.

    The risk is that SPR market-managing ultimately gets some signals wrong and sends wrong signals. Steep excise taxes on petrol and diesel would be much simpler, and would send a much more convincing and credible signal of American commitment to energy conservation.

    Funny how you JDH model oil shocks as assymmetric events and most of us blithely focus on the negative impact oil price shocks to the exclusion of “positive” shocks such as the low real prices experienced during most of the 1990s. Net-importing country citizens have enjoyed an enormous ‘tax break’ since oil moved from over US$140/b to near US$50/b.

  13. John Lee

    @Tom : Haha, thats a good one.
    The Oil Shock of 2007-08 was only and fully related to speculation.
    Long-term influences of oil production and demand are not interesting for speculative investors, thats a fact for sure.

  14. DickF

    kharris,
    Consider the US credit (liquidity) expansion was a worldwide phenomenon. The increase in liquidity stimulated a boom that producers thought was real. The problem was that it was money based stimulation rather than real savings based. The result is that the producers, especially the emerging nations, reacted to the US boom and tooled up to meet the artificial demand. Because this was an export demand transportation and oil demand exploded.
    Once the money illusion became manifest – that there was no real savings – the artificial boom ran its course and the bust began in the US. The exporting nations suddenly faced a crash in demand and the malinvestment of the assets that had been mistakenly redirected into the export business.
    Now back to oil, it is simply a factor of production. If an artificial boom cretes waste and malinvestment in other factors we should also expect it to create waste and malinvestment in oil.
    It all comes back to FED and government incompetence.
    All the talk of elasticity is just a recognition of shifting levels of demand due to the artificial stimulation. The Professor doesn’t address why the elasicities changed but it actually all makes sense. This is a perfect fit with the Professor’s post.

  15. ben claassen

    Prof. Hamilton:
    The price elasticity of energy, either in gasoline price, crude oil price , or my field, electricity prices, continues to be complicated by the mismatch between the cost and the end use value.
    The end use value for some electrical loads is huge, such as supply to a hospital. Similarly, motor fuel uses will continue to have value above cost, as long as the end use supports the cost. An example is the truck delivery of perishable foods with the fuel cost passed on.
    Thus, price elasticity is the result of a composite of the individual consumers balance of price and value. As has been well studied, the poorest nations show the largest reductions in global demand, when prices rise, since consumers with no money cannot buy any oil.
    Over a longer term, a capital investment can lead to a fuel (energy source) swap out and change the balance of the price and value of different energy sources.
    That said, my concern is that the oil price will rise again in the next few years, even as the economy lags. The potential driver/mechanism for this price rise will be a drop in supply to the point where consumers with the lowest end use value have left the market and consumers with the higher value end uses pay the price, whatever it is– near zero elasticity.
    The counter for this potential price rise, a factor in any study of price elasticity, is the enactment of a carbon tax or an oil/gasoline tax. On the electricity side, the switch to electricity for transportation, is a long term influence on oil demand/price-elasticity. Currently, there is a lack of a model of where the electricity supply will come from and at what cost.
    How are these factors, particularly the potential for a carbon tax, applied in your price elasticity work?

  16. FairEconomist

    Backing up lilnev and spencer, it’s pretty much conventional wisdom that short-term price elasticity for oil is very low but long-term elasticity is fairly high. E.g. see the references to research by Gary Becker in this Economist article.

  17. MikeR

    FiarEconomist, correct me if I am wrong, but woulnd’t it more correct to say that in the short term, the elasticity is very low but in the long term it is still low, but higher than the short term (still less than 1)?

  18. Hitchhiker

    It only stands to reason that the price elasticity at $2 a gallon is not going to be the same price elasticity at $4 a gallon of gas. I would say peoples’ marginal personal elasticity was increasing at an increasing rate. At what price point are people going to simply stop driving and be forced into substitutes? I think $4 a gallon gas hit this point for those in the bottom income quintile. If you are living paycheck to paycheck you are going to have a pretty high price elasticity especially if your commute is of any length. For those in the top income brackets, I would expect no price elasticity at all.
    Besides, why do we need more production when we can simply force demand down by telling everyone the planet is overheating and if they don’t stop driving we are all gonna drown. If they’re gonna control supply absolutely, they gotta control demand also. I think Barbara Boxer is right, we just need to become her slaves and she will feed us and we won’t need any more energy. That way, she will have plenty for herself and her good friends and we can live with that right? All for one and one for all?
    Your obedient serf, Tim.

  19. Steve Kopits

    If I understand correctly, you appear to be suggesting two models of demand adjustment: continuous and disruptive. We had continous demand adjustment from 2005, with oil consumption moving from Japan and the EU to China and other emerging economies without material detriment to the global economy. From late 2007, US consumption was also beginning to move emerging economies, albeit in the context of an increasingly rocky global economy.
    By late summer 2008, continuous adjustment had given way to disruptive adjustment, with the global economy in free fall. In disruptive adjustment, fundamental economic relationships are re-ordered in a traumatic way.
    The events of the last year would appear to suggest that continous adjustment is bounded, ie, it cannot occur at just any speed. When the ‘speed limit’ is exceeded, you see disruptive adjustment–a collapse in demand due to recession.
    As you point out, we are in an era of what appears to be peak oil, as well as the period in which China is motorizing. We may anticipate, therefore, that supply growth will be unable to keep pace with demand growth, just as it has since 2005. By implication then, the story of oil will again be about the re-allocation of consumption from the OECD countries to the non-OECD countries, and the process likely to continue through 2035 or so (depending on India in the latter years).
    How will this re-allocation occur? If we allow that the pace of continuous adjustment is constrained, then you would appear to be predicting a series of painful recessions between now and then.
    Therefore, the chief goal of energy (and arguably economic and foreign) policy would appear to be prevent oil prices rising to a level which induces disruptive adjustment. What level would you posit? A price of $150/barrel oil might be a reasonable target.
    This, in turn, would suggest a managed price regime, in effect, what you appear to be endorsing in using the SPR to quell speculation. I think there is a conceptual question of the purpose of the reserve. Personally, I view it as a national security reserve, and therefore not an appropriate tool for economic management.
    Instead, the appropriate tool would be to pay the low cost producers (read ‘Saudi’s’) to establish capacity solely for the purposes of managing prices at the extremes and allowing time for continuous adjustment. This is akin to the power industry, in which producers are paid capacity charges entirely for the purposes of maintaining capacity in times of need.
    In any event, if we are in agreement that the chief goal of policy is to prevent disuptive adjustment, then Secretary Chu’s strategy will have to be modified from its current course.
    You can read some additional analysis on related topics here (with an update coming out this weekend):
    http://www.dw-1.com/files/files/404-09-02%20RESEARCH%20PAPER%20Oil%20Demand%20and%20Recession.pdf

  20. Vangel

    I like a much simpler and more plausible explanation. When the Russians were bragging about being able to bring 2.5 million barrels on line the Saudis actually believed them and cut back their production. As production stagnated demand growth chipped away at surplus capacity and prices rose as the risk of supply disruptions increased. Add to this the fact that the world’s largest fields, which have produced much of the light sweet crude that we have used over the past half century have peaked, and that the annual depletion rate stands at around 6.5% it is no surprise that prices increased.
    While a combination of increased production out of Saudi Arabia and a slight decrease of demand made crude vulnerable to a sharp pull-back there is little doubt that depletion is a major problem going forward and that crude prices will rise sharply over the next few years.

  21. Highlander

    The good professor’s work is from the same school of thought that brought us the Wall Street “Quants” (short for quantifers).
    These are the same boys with Phds, who assured the world,they had through their cleverly constructed algorithims conqured the investment risks in our securities markerts.
    Can you say AIG, Lehman Brothers, Citi Bank, Wachovia Bank, Washington Mutual, IndiMac, Bear Stern,and dozens of others. My god! What a disaster these egg headed twits help to set the stage for.
    In my long and much blessed life I have been amongst other things, a professional commodities trader, and a political consultant for everything from 3 presidential races to county dog catcher ( animal control officer).
    It was NO ACCIDENT of fundamental market forces and timing, that 6 months before the Presidential election oil futures go vetical to record highs, and then almost as quickly plunge to new lows.
    I’ve been in the oil markets with My very own personal money on the line. The oil markets are RIGGED folks!
    A Soros like character would have had the political interests, the market knowledge,and the necessary capital, to intiate such a manipulation just to make sure Obama was elected. And then have people so economically panicked, the nation would accept any politcal agenda that promises economic salvation. Plus the manipulator would have made billions on riding the long side and short side of the oil market manipulation.
    I’m sorry professor the nation’s investment community bought into you an your cohorts academic snake oil, and we are $50 trillion or so lighter for it! Go back to what ever academic black hole you came out of, and continue to rip off our young people with the vastly overpriced and poor quality product you people call a college education.
    At the end of the day our bitter wall street experience has shown you and your formulas are no better than tossing out chicken bones. But at least the chicken bone technique is more honest and one hell of a lot less destructive!

  22. victoria

    i like 2 ask
    is this analysis of yours on a global level or is ur outlook on a particular economic level.?

  23. John Lee

    @Highlander : May I kindly ask you, to be more polite to Mr. Hamilton.
    @Highlander : Your opinion related to oil speculation, the 2007-2008 oil shock and investor interests is fully correct, of course.

  24. JDH

    Charles: The relation between logs and elasticities is captured by the equation d ln y/ d ln x = (x/y) dy/dx.

    Victoria: The assumption is that it is a global market for crude oil, with the relevant quantities being total global production and total global consumption.

  25. DickF

    I realize that it is blasphany to question accepted economic dogma but elasticity nothing more than a different way of measuring demand. It is good for econometrics, but it introduces error into economic thinking and real life policy making. That error comes when we confuse a mathmatical entity with a behavioral condition.
    Note the professor’s comment, “A short-run elasticity of 0.06 for crude petroleum demand could certainly be defended on the basis of estimates in the literature, though so could a higher or lower value.”
    Do not attempt to read too much into statistical measures of behavior.

  26. Roger Chittum

    2 serious problems with the analysis:
    1. It assumes sellers behave like commercial profit maximizers. But in fact the major sovereign sellers of crude oil are not–they behave politically to balance budgets and stabilize demand. So in the high price ranges we had a year ago, major producers were willing to sell the same amount of oil–or even more–at lower prices, and they actively tried to talk down prices because they feared a short-term collapse in demand followed by long-term shifts away from petroleum use (such as happened after 1982). The result is that in high price ranges the supply curve is essentially congruent with the demand curve–not upward sloping as Krugman initially drew it or vertical as Hamilton and the later Krugman drew it. One result of supply and demand curves being congruent or parallel or crossing at very acute angles is extreme instability in the location of the equilibrium point, which is related to . . .
    2. Spot prices of OPEC oil are not set by negotiation between buyer and seller, as this analysis assumes. Instead, the price is set by long-term contract price formulas that are driven by crude oil futures prices. The report of the Oxford Institute for Energy Studies is here. http://www.oxfordenergy.org/pdfs/WPM31.pdf My summary of it is here. http://www.realitybase.org/journal/2008/7/4/international-crude-oil-markets-dont-function-like-textbook.html The futures market, I suggest, was responding to fundamentals of supply and demand–for futures contracts. The bulls dominated the bears in crude oil futures and drove up the prices–just as they did in other bubbles from dot-com stocks to residential real estate. These players counted on momentum to make money and were for the most part not hedging transactions in wet oil. When the momentum reversed, they all rushed for the door at once. Mark Thoma noted coordinated moves in prices of crude oil futures and other commodities despite the tiny likelihood that there were coordinated changes in fundamentals for all commodities. http://economistsview.typepad.com/economistsview/2008/08/commodity-price.html
    “I’ve been telling a story about trend movements in commodity prices that is based upon movements in fundamentals, a story similar to that shown in the diagrams (as opposed to alternatives such as a speculative bubble or price manipulation story). One argument I’ve been using against any story that relies upon particulars in, say, the oil market to explain commodity price movements is that the prices of all commodities have moved together, we see the common co-movements even in markets where speculation is outlawed or non-existent for some other reason, the inventory changes have not been consistent with a speculation story, etc. For that reason, whatever it is that is driving commodity prices, it must be common to all markets, whatever is driving prices around cannot be something unique to a particular market (unless it can somehow bleed over into other markets, e.g. if oil is an input to the production of other commodities, we would see the prices of these commodities increase after an oil price increase, though a lag in the relationship would be expected, and, notably for the points that below, the price change would differ across commodities according to relative energy intensity in production). One story out there along these lines is a change in the laws regarding speculative investment that would cause an infusion of speculative activity in all markets simultaneously. But – in addition to the other objections mentioned above – the movements in commodity prices, at least as I’ve observed from inspection of graphs, do not seem to be tied closely enough to the change in the laws regarding speculation for this story to hold, though I haven’t looked at this evidence in detail and I’m open to more evidence on this issue.”

  27. marku

    Roger C:
    The graph I linked to above goes not agree with:
    “The result is that in high price ranges the supply curve is essentially congruent with the demand curve–not upward sloping as Krugman initially drew it or vertical as Hamilton and the later Krugman drew it.”
    In fact it does support that the supply curve goes vertical at ~74-75mmbpd

  28. Roger Chittum

    marku: You say the (dramatic) plot of volume vs. price is the supply curve. Couldn’t you equally well call it the demand curve? It shows outcomes not propensities which I thought were meant to be reflected in aggregate supply and demand curves.

  29. Ed

    There seem to have been two phenomena of oil price increases: the rapid rise to $140 in 2008 followed by a collapse, and a steady multi-year rise in real terms after 2002, which seems to be continuing. I’m impressed by the paper, but it seems necessary to distinguish between the two, they likely have very different causes and consequences

  30. kharris

    DickF,
    Can’t go with blanket explanations, especially when they have a moral twang to them. The problem in oil was a mismatch between supply and demand. There are a lot of things that could explain why supply didn’t respond quickly to a rise in price, but “malinvestment” certainly doesn’t make sense. In the the short run, it is the failure to “malinvest” in the oil sector that is preventing a repetition of problems oil firms suffered in the post-embargo price collapse. What our host is doing is examining an issue in detail. That seems a better approach that putting forward a monolithic cause for every side of every problem.

  31. Walt French

    I was pleased to see a blog post some sensible work on energy.

    My macro work was a couple of decades ago, so I’m surprised that such a well-reasoned post doesn’t reference widely-used forms for energy demand models. Those models estimate both long- and short-term price and income elasticities; omitting important variables typically causes mis-estimation of these very important elasticities. DOE, and every energy-related company must have dozens of economists who have more or less agreed on the most insightful way of estimating these sensitivities, and continue to refine their decades-old work.

    For the reasons mentioned above (a lot of energy use is a component of some other service/good rather than an end-consumption item), alternatives can take a while to come on line; due to habituation, end-use (how much we leave lights on at night) also lags the “economic” use. We take time to adjust to different prices or how well off we otherwise feel.

    Now factor in speculation and hoarding (panic buying of oil futures, say, by an airline that needs to guarantee that it can keep flying without bankrupting itself) and the very high uncertainty of future prices. The result should give a fairly good description of prices and demand, a fair bit more fine-tuned than the simple math above.

    @Highlander, this sort of work is also what your power company uses to ensure you will have AC in the summer and that agriculturalists use to estimate whether to raise or slaughter hogs. Econ 101, maybe 102. The modeling has about the same resemblance to the markets’ errors and fraud that you decry as your angry post has to a speech by Hitler. (Unless I misread your piece and you actually are blaming scapegoats for some other purpose.) If you don’t like dispassionate analysis, you really shouldn’t come to this site.

  32. bakho

    One part of the oil price is refinery capacity. If we look at the 1978 oil shock, and the Carter energy policy, we see that consumption dropped by over 20% an refinery capacity dropped below 70%. This caused a lot of small and inefficient refineries to go out of business.
    It was only in 2000 that oil consumption returned to its 1978 levels. Refiners are in a tricky situation. Expanding capacity means refining oil that is lower quality and more expensive to produce and means that the products will be higher priced and profit margins lower. If the public responds to price increase by conservation and efficiency increases, then investment in new refining capacity has several strikes against it.
    As a public policy, it makes sense to demand fuel efficiency that maintains a reasonable gap between demand and capacity. After all, that is what we do with electricity. Every appliance has SEER standards, even toilets have water use standards. It only makes sense to have CAFE standards to guard against oil shocks.
    http://www.eia.doe.gov/emeu/aer/pdf/pages/sec5_20.pdf

  33. bakho

    I should have written that refinery UTILIZATION (not capacity) dropped below 70% in 1983 as a result of conservation. A doubling of fleet fuel efficiency from current levels would have a similar effect on refinery utilization. A major switch to electric or alternate fuel cars would have similar effects. One can expect Big Oil to fight this.

  34. Roger Chittum

    Re: bakho’s comments. This is one of the serious practical problems of energy policy. I was an officer of an energy company in 1983 when over 100 refineries were shut down permanently. 3 of them were ours. The company was able to survive around the one remaining refinery, but I had to look for a new career. There have been complaints that environmental rules have prevented the construction of new grass-roots refineries (that’s true, but expansions have been quite adequate to meet demand), and other complaints that consumption of motor fuels needs to be decreased, perhaps dramatically. The federal government has made no definitive decision that anybody could rely upon as being set for the long term. If I were still in the refining business, what should I do?

  35. Get Rid of the Fed

    I agree with Roger C.

    See figure 1 at this link from Krugman.

    http://web.mit.edu/krugman/www/opec.html

    For oil and for various reasons, is it possible that both the aggregate supply and aggregate demand curves were both vertical between price equilibrium and price high?

    For commodities in general, is it possible that speculators were using cheap leverage (cheap debt) from the fed to raise the price of commodities because they knew many emerging markets (especially china) were price insensitive because they were focused on exports to the high wage countries (especially the USA)?

  36. Roger Chittum

    GRF: That’s interesting! I could not find a date on the linked Krugman paper, but Calculated Risk refers to it as “a few years ago” when he commented on Krugman’s blog 3/19/08. So had PK forgotten his own work when in a series of blog posts last spring he started with upward sloping supply curves and ended with a vertical supply curve. I forget my prior work and opinions all the time, but I don’t have the Bank of Sweden Prize.

  37. Get Rid of the Fed

    Roger C, I think I got the link from Calculated Risk, but I do not remember when.

    Ah yes, if I could just remember a lot of things I have forgotten. ~smile~

  38. Sid Dastidar

    I am confused, professor. I think the low supply elasticity led to this increase in price. The low demand elasticity also contributed, which implied that consumers didn’t shift their demand to “substitutes”. But, given the increase in demand for oil, it is low supply elasticity (i.e. the production lagged behind the increased demand/ price change) that caused the price movement.

  39. Ned

    At what price point are people going to simply stop driving and be forced into substitutes? I think $4 a gallon gas hit this point for those in the bottom income quintile

    In the UK we pay up to £1.00 a litre.

    Large cars such as 4X4s market values have fallen dramatically as people ditch them. The government has also increased car tax on large vehicles as well.

    The cost of fuel has also caused airlines such as Zoom who operated Edinburgh flights to Canada to cease trading, I am sure other airlines will follow.

  40. TK

    @RC:
    I too remain concerned with the chokepoint problem of refinery capacity. What would be wrong with the Federal government (the TVA, perhaps) building a refinery and then simply leasing it to the highest bidder during times of peak demand when capacity becomes an issue? It’s no more ridiculous than many of the TVA’s botched energy ventures, and would clearly serve the national interest and remedy an imperfection in market mechanics. The compelling message to me in all of this is that it CLEARLY serves the national- and global- interest to avoid boom-bust cycles with key commodities in the future, and the government is the best hope of a “honest broker” to facilitate this, particulary as it pertains to infrastructure investments such as refinery construction.

  41. warren wolf

    Demand curves change quickly and radically when there is a perception of significant change in supply. When price is expected to rise, consumers increase individual inventories, automobile gas tanks. When price is expected to fall, they delay purchases. Most consider this behavior prudent. In the case of gasoline, the inventory impact is huge, but apparantly ignored. Real demand was falling long before it was reported. Why is individual inventory capacity ignored? It is huge for both gasoline and fuel oil.

Comments are closed.