To assess the consequences of an oil price shock for markets it is important to identify its type. A new method separates oil supply shocks, oil market-specific demand shocks and global growth shocks. Supply shocks have accounted for about 50% of price volatility since the mid-1980s. Oil market-specific shocks drive a wedge between the growth of developed and emerging economies and hence matter for exchange rate trends. Global demand shocks to oil prices do not cause such a divergence.

Caldara, Dario, Michele Cavallo, and Matteo Iacoviello (2016), “Oil Price Elasticities and Oil Price Fluctuations”, Board of Governors of the Federal Reserve System, International Finance Discussion Papers 1173.

The post ties in with the subject of information efficiency and particularly the “best practices for tracking macro trends”, which can be found on the summary page here.

The below are excerpts from the paper. Headings and cursive text have been added.

Identifying types of oil price shocks

“Empirically distinguishing among competing sources of [oil price] fluctuations…has proved to be an elusive task.

  • [In] an oil market with a downward-sloping demand curve [demand declining with price] and an upward-sloping supply curve…demand and supply shocks jointly affect oil prices and production…Oil supply shocks generate a negative co-movement between prices and quantities, while oil demand shocks generate a positive co-movement between prices and quantities. That is, the unconditional zero correlation between prices and quantities observed in the data is accounted by two shocks that generate non-zero conditional correlations.
  • An additional challenge is to disentangle demand shocks that are specific to the oil market from demand shocks that originate from changes in global economic activity…Current and expected developments in the global economy can lead to shifts in the demand for oil and, hence, affect the identification of exogenous oil market-specific shocks. In turn, such shocks can lead to changes in economic conditions.”

“Global activity is hard to measure. Our novel approach is to use three indicators of real economic activity that provide a rich and comprehensive characterization of oil demand. We construct two separate indicators based on industrial production, one for emerging economies, and another for advanced economies, dating back to the mid-1980s. Our third indicator is an index of industrial metal prices…Metal prices represent a…bellwether of shifts in current and expected economic activity at the global level.”

“To achieve [the identification of various oil price-related shocks], we implement a structural vector autoregressive (SVAR) model of the oil market using a new identification methodology…to provide a full characterization of the two-way interaction between the oil market and the global economy…

  • The supply shock captures disturbances to oil supply due, for instance, to wars, sanctions, and technological progress in the oil industry…
  • The oil-specific demand shock captures changes in oil prices due to speculation, changes in oil intensity, and precautionary demand for oil due to oil price volatility…
  • [The global growth shock] means…that…for a given oil price, demand rises as global activity increases.”

“We set 1985 as the starting date.”

The importance of the different types of oil price shocks

Oil supply shocks are the main driving force of oil market movements, accounting for 50 and 40 percent of the volatility of oil prices and oil production, respectively. Shocks to global economic conditions also play an important role, explaining about 35 percent of the volatility of oil prices, and 25 percent of the volatility of oil production… and are important drivers of oil prices during some historical episodes.”

“Movements in oil prices driven by global demand mostly reflect changes in oil demand from emerging rather than advanced economies.”

The consequences of oil shocks

“Shocks that originate in the oil market have asymmetric effects on activity in advanced and emerging economies.”

A drop in oil prices driven by supply shocks boosts economic activity in advanced economies, whereas it depresses economic activity in emerging economies…A drop in oil prices driven by oil market shocks, regardless of whether the shock originates from supply or demand, depresses economic activity in emerging economies. A drop in oil prices boosts economic activity in advanced economies only if it is supply-driven.”

“Emerging economies in our sample produce about 35 percent and absorb about 40 percent of global oil availability. By contrast, the advanced economies produce 20 percent and consume 40 percent of global oil availability.”

“The solid lines in…[the panel of charts below] show the median impulse responses…to a one standard-deviation oil supply shock… An unanticipated disruption in oil supply reduces production by about 0.75 percent and elicits a persistent increase in oil prices, which rise by 6 percent on impact and remain elevated thereafter. On the activity side, the response of activity between advanced and emerging economies is markedly different. Industrial production in advanced economies declines gradually, bottoming out at -0.35 percent two and a half years after the shock…Industrial production in emerging economies rises rapidly, peaking after six months at 0.2 percent above baseline.”

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