Understanding Crude Oil Prices

The $140/barrel price in the summer of 2008 and the $60/barrel in November of 2008 could not both be consistent with the same calculation of a scarcity rent warranted by long-term fundamentals.

What caused the high price of oil in the summer of 2008? In Understanding Crude Oil Prices (NBER Working Paper No. 14492), James Hamilton reviews a number of theories, including commodity price speculation, strong world demand, time delays or geological limitations on increasing production, OPEC monopoly pricing, and an increasingly important contribution of the "scarcity rent" associated with oil. He suggests that there is an element of truth to all of these explanations.

The key features of any account, he writes, are the low price elasticity of demand for oil; the strong growth in demand from China, other newly industrialized economies, and the developing Middle East itself; and the failure of global production to increase. These factors explain the initial strong pressure on prices that may have triggered commodity speculation. Speculation could have edged producers like Saudi Arabia into the discovery that small production declines could increase current revenues and might be in their long-run interest as well. The strong demand may also have moved us into a regime in which scarcity rents, which were negligible in 1997, were perceived to be an important permanent factor in the price of oil.

Hamilton explores three broad ways to explain changes in oil prices: a statistical investigation of the basic correlations in the historical data; a look at the predictions of economic theory as to how oil prices should behave over time; and a detailed examination of the fundamental determinants and prospects for supply and demand. In terms of the statistics, he notes that changes in the real price of oil historically have tended to be permanent, difficult to predict, and governed by very different regimes at different points in time.

According to economic theory, three restrictions of the time path of crude oil prices should hold in equilibrium, arising from storage arbitrage, financial futures contracts, and the fact that oil is a resource than can be depleted. These connect the spot price of oil today to the value that market participants expect the price to be in the future. Just as the current price of a stock reflects what people expect about future earnings, making the actual change in stock prices very difficult to predict, the current price of oil should reflect expectations of future fundamentals, making changes in the price of oil hard to predict. The broad movements of the price of oil and oil futures contracts are consistent with these theoretical restrictions.

The price elasticity of demand for oil (that is, the response of the demand for oil to changes in its price) is challenging to measure but appears to be quite low, Hamilton writes, and it seems to have declined over time. Income elasticity (that is, the response of the demand for oil to changes in income) is easier to estimate: for countries in an early stage of development it is close to unity, but it is substantially less than one in recent U.S. data.

On the supply side, Hamilton notes that there are problems with interpreting OPEC as a traditional cartel and with cataloging intermediate-term supply prospects, despite the very long development lead times in the oil industry. The path of depletion for existing oil reserves is related to the past and possible future geographic distribution of production. Although the standard theory of exhaustible resources suggests that the difference between the price and marginal extraction cost of oil should rise at the interest rate, in fact, the real price of oil declined steadily between 1957 and 1967, and fell sharply between 1982 and 1986. This record led many economists to conclude that, at least historically, oil prices had not been significantly influenced by the possibility of exhaustion. However, nothing in the theory says that just because the scarcity rent has been negligible historically, it's going to continue to be negligible in the future.

Overall, Hamilton concludes, the low price-elasticity of short-run demand and supply, the vulnerability of supplies to disruptions, and the occurrence of a peak in U.S. oil production explain the general behavior of oil prices over the period of 1970-97. Although the traditional economic theory of exhaustible resources does not fit in an obvious way into this historical view, the profound change in demand coming from the newly industrialized countries and recognition of the finiteness of oil offer a plausible explanation for more recent developments in oil prices.

Still, Hamilton writes, "the $140/barrel price in the summer of 2008 and the $60/barrel in November of 2008 could not both be consistent with the same calculation of a scarcity rent warranted by long-term fundamentals." He nevertheless concludes that "if demand growth resumes in China and other countries at its previous rate, the date at which the scarcity rent will start to make an important contribution to the price, if not here already, cannot be far away."

-- Matt Nesvisky