Energy Economics – I Jeffrey Frankel Harpel Professor, Harvard University. ADA Summer School, Baku, Azerbaijan 7-9 July , 2010. (1) Long-term trends: Are oil prices fated to rise as the world runs out? (2) Shorter-term movements: What causes swings such as the 2008 price spike?.
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ADA Summer School, Baku, Azerbaijan
7-9 July , 2010
Are oil prices fated to rise as the world runs out?
What causes swings such as the 2008 price spike?
the local price of oil = ($ price on world markets) x (the exchange rate).
Whoever currently has claim to the resource can be confident that it will retain possession,
1 1973 Arab oil embargo
2. 1979 fall of Shah of Iran
3. 2008 spike
with interest rates close to zero,
apparently believes that the rate of return on oil reserves is higher if he doesn't pump than if he does:
If there is a constant convenience yield from holding inventories?
than the interest rate, by that amount.
E Δp oil = interest rate + costs – convenience yield
than the prediction that price will rise?
Krautkraemer(1998)andWright & Czelusta(2003, 2004, 2006).
 E.g., Deffeyes (2005).
Cuddington (1992), Cuddington, Ludema & Jayasuriya (2007), Cuddington & Urzua (1989), Grilli & Yang (1988), Pindyck (1999), Hadass & Williamson (2003), Reinhart & Wickham (1994), Kellard & Wohar (2005), Balagtas & Holt (2009) and Harvey, Kellard, Madsen & Wohar (2010).
The wager of Paul Ehrlich against Julian Simon
High elasticities repeatedly been proven false in the past does not imply that it will always be so in the future.
Low elasticitiesA given rise in demand causesa small price rise or a big price risewith with
in demand drives up
Supply & demand for oil
Supply & demand for oil
In the medium run,
& developed in new countries.
In the medium term, oil may be subject to a cob-web cycle, due to the lags in response:
High interest rates reduce the demand for oil, or increase the supply, through 3 channels: ¤ by increasing the incentive for extraction today rather than tomorrow; ¤ by decreasing firms' desire to carry inventories (oil stocks held in tanks or tankers) ¤ by encouraging speculators to shift out of spot oil contracts, and into treasury bills.
Regressors Real interest rateStandard Significant
coefficient error at 10%
1. Real rate -5.96 0.29 *
2. Real rate -0.69 0.35 *
& linear trend
The spot-futures spread, risk & Industrial Production also appear significant in variants of the inventories equation.
Source: Table 4, Frankel, “The Effect of Monetary Policy on Real Commodity Prices,” in Asset Prices and Monetary Policy, edited by John Campbell (University of Chicago Press), 2008, pp.291-327
Influences on oil inventories, repeatedly been proven false in the past does not imply that it will always be so in the future.continued
Exogenous disruptions in world petroleum supply.
Date Event Drop in world Drop in U.S.
oil production real GDPNov.1956 Suez Crisis 10.1% -2.5%
Nov.1973 Arab-Israel War 7.8% -3.2%
Nov.1978 Iran Revolution 8.9% -0.6%
Oct.1980 Iran-Iraq War 7.2% -0.5%
Aug.1990 Persian Gulf War 8.8% -0.1%
Source: Hamilton (2003, p.11).
Don Kohn and Paul Krugman: low interest rates or speculation
could not be the causes, because oil inventories were low.
It is true that low interest rates or speculation, other things equal,
should in theory increase firms’ desire to hold inventories.
US crude oil inventories did not appear
especially low or high in the graph above,
showing June 1998-June 2008(from Bloomberg).
World markets are relatively integrated, speculation
so it is world inventories that should matter most.
Oil inventories in developed countries were above average during most of the year, as the graph shows.
They rose in January 2008, when the Fed aggressively cut interest rates.
These numbers are far from conclusive…
Source: Oil Market Report:
International Energy Agency
bubbles or destabilizing behavior.