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Causes and Consequences of Oil Price Shocks: a VECM Decomposition Analysis
Gbadebo OladosuResearch EconomistOak Ridge National LaboratoryKnoxville, TNoladosuga@ornl.gov
The potential causes of recent sharp declines in the oil price include changes in the global economic outlook, changes in oil supply and demand, geopolitical events, appreciation of the U.S. dollar, and responses by oil producers and consumers, among others (Baffes et al, 2014). There are a number of qualitative evaluations of the roles of these factors, but quantitative estimates of their contributions to the oil price change and the economic consequences are just emerging (Arezki and Blanchard, 2014; Baffes et al, 2015; Hou et al., 2015; EIU, 2014; Tokic, 2015). Quantitative assessments are indispensable because the economic consequences of oil market changes depend on the composition of the underlying drivers and their net market impacts (Kilian, 2014). In addition, understanding the relative importance of the different drivers is important to gauging the future direction of the oil market.
This study employs a recent quarterly vector error correction (VEC) model of the United States (U.S.) economy to quantify the roles of several important oil market and macroeconomic drivers, and their potential economic implications (Oladosu, 2015). The end-date of the data has been updated from 2014:Q2 to 2015:Q1. Historical decomposition analysis is performed to quantitatively evaluate the contributions of oil market and macroeconomic shocks to changes in the oil price and the real U.S. GDP.
Estimates of oil price shocks from the model line up well with periods of exogenous events that affected the oil market between 1973 and 2014. Thus, the turbulent market of the 1970s is reflected by a large positive oil price shock in the first quarter of 1974. However, the oil price collapse during the 2008/2009 recession is not shown to be due to exogenous oil price shocks, matching other findings in the literature that this was largely a consequence, rather than a cause, of that global economic recession. In contrast, the most recent oil price collapse since the third quarter of 2014 is shown to be partly due to exogenous shocks to the oil price. Figure 1 shows the contributions of shocks to the real WTI oil price and real U.S. GDP since the first quarter of 2014. The total contribution from all shocks, shown as “Total” in Figure 1, is the difference between the model’s forecast, given data up to 2013:Q4, and the actual data for the period. Contributions from the ten shocks in the model have been aggregated into six groups: oil price shocks, oil demand shocks, real GDP shocks (productivity shocks), oil supply shocks (non-OPEC production, OPEC Production to Capacity Ratio, and OECD Petroleum Stock), financial shocks (federal funds rate, real money supply, and the inflation rate), and real exchange rate shocks. These results suggest that the most significant sources of recent changes in the oil price are exogenous oil price shocks and financial shocks. Contributions from the global oil demand shock over this period are small, with changing signs. The largest contributions to changes in the real GDP are from real GDP (productivity) shocks and financial shocks. Contributions from oil price shocks to the real GDP are negative up to the third quarter of 2014. Interestingly, contributions to the real GDP from oil supply shocks, oil price shocks, and real exchange rate shocks are positive for the remaining quarters, reflecting the positive effects of increasing of U.S. oil production, significant oil price decline and the strengthening dollar.
Figure 1. Contributions of shocks to the real U.S. GDP and real WTI oil price: 2014:Q1-2015:Q1
Results of the analysis in this study show that, unlike the 2008/2009 oil price collapse, the large decline in oil prices since the third quarter of 2014 are in large part due to a negative oil price-specific shock, corresponding to the disappearance of tight oil market sentiments. Since expectations about the level of U.S. oil production during this period were largely correct, the disappearance of tight oil market sentiments reflects an acknowledgment that the elevated level of U.S. oil production will likely be sustained for several more decades. The change in market sentiments was also supported by OPEC’s decision to maintain production levels, rather than its traditional approach of cutting production to prop up the oil price. However, our results also show that financial shocks contributed about one-third of the total change in the oil price since the third quarter of 2014, reflecting a deterioration of the global economic outlook. Overall, these findings imply that the outlook for oil prices depend on both the return of tight oil market sentiments and changes in the global economic outlook. On the one hand, sustained U.S. oil production capacity implies that lost contributions to the oil price from the tight oil sentiment factor cannot be recovered in the near future. However, this also depends on global investments in oil production and potential geopolitical events. On the other hand, a quick improvement in the global economic outlook means that contributions to the oil price decline from this factor can be recovered. Yet, further deteriorations in the global economic outlook could send oil prices even lower. In terms of consequences for the U.S. GDP, a lower oil price due to reduced oil market tightness has positive effects on the economy, whereas a deteriorating global economic outlook, although also lowering oil prices, could impose negative impacts on the economy.
Arezki, R., & Blanchard, O. (2014). Seven Questions About The Recent Oil Price Slump. IMFdirect December, 22, 2014.
Baffes, J., Kose, M. A., Ohnsorge, F., and Stocker, M. (2015). The great plunge in oil prices: Causes, consequences, and policy responses. World Bank Policy Research Note, 15(01).
Economic Intelligence Unit – EIU (2014) The Business of Cheaper Oil. The Economic Intelligence Unite Limited, London.
Hou, Z., Keane, J., Kennan, J., and te Velde, D. W. (2015). The oil price shock of 2014. Working Paper. Overseas Development Institute, London, UK
Kilian, L. (2014). Oil Price Shocks: Causes and Consequences. Annual Review of Resource Economics, 6(1), 133-154.
Oladosu, G. (2015). Oil market shocks and the economy in a quarterly structural vector error correction model of the United States economy. USAEE Working Paper No. 15-202, February 2015.
Tokic, D. (2015). The 2014 oil bust: Causes and consequences. Energy Policy, 85, 162-169.