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Understanding the Estimation of Oil Demand and Oil Supply Elasticities

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  • Lutz Kilian

Abstract

This paper examines the advantages and drawbacks of alternative methods of estimating oil supply and oil demand elasticities and of incorporating this information into structural VAR models. I not only summarize the state of the literature, but also draw attention to a number of econometric problems that have been overlooked in this literature. Once these problems are recognized, seemingly conflicting conclusions in the recent literature can be resolved. My analysis reaffirms the conclusion that the one-month oil supply elasticity is close to zero, which implies that oil demand shocks are the dominant driver of the real price of oil. The focus of this paper is not only on correcting some misunderstandings in the recent literature, but on the substantive and methodological insights generated by this exchange, which are of broader interest to applied researchers.

Suggested Citation

  • Lutz Kilian, 2020. "Understanding the Estimation of Oil Demand and Oil Supply Elasticities," Working Papers 2027, Federal Reserve Bank of Dallas.
    • Handle: RePEc:fip:feddwp:88693
    DOI: 10.24149/wp2027
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    1. Kilian, Lutz & Lee, Thomas K., 2014. "Quantifying the speculative component in the real price of oil: The role of global oil inventories," Journal of International Money and Finance, Elsevier, vol. 42(C), pages 71-87.
    2. Christopher R. Knittel & Shinsuke Tanaka, 2019. "Driving Behavior and the Price of Gasoline: Evidence from Fueling-Level Micro Data," NBER Working Papers 26488, National Bureau of Economic Research, Inc.
    3. John Coglianese & Lucas W. Davis & Lutz Kilian & James H. Stock, 2017. "Anticipation, Tax Avoidance, and the Price Elasticity of Gasoline Demand," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 32(1), pages 1-15, January.
    4. Kilian, Lutz, 2022. "Facts and fiction in oil market modeling," Energy Economics, Elsevier, vol. 110(C).
    5. Laurence Levin & Matthew S. Lewis & Frank A. Wolak, 2017. "High Frequency Evidence on the Demand for Gasoline," American Economic Journal: Economic Policy, American Economic Association, vol. 9(3), pages 314-347, August.
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    7. Alquist, Ron & Kilian, Lutz & Vigfusson, Robert J., 2013. "Forecasting the Price of Oil," Handbook of Economic Forecasting, in: G. Elliott & C. Granger & A. Timmermann (ed.), Handbook of Economic Forecasting, edition 1, volume 2, chapter 0, pages 427-507, Elsevier.
    8. Inoue, Atsushi & Kilian, Lutz, 2013. "Inference on impulse response functions in structural VAR models," Journal of Econometrics, Elsevier, vol. 177(1), pages 1-13.
    9. Jamie L. Cross & Bao H. Nguyen & Trung Duc Tran, 2022. "The role of precautionary and speculative demand in the global market for crude oil," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 37(5), pages 882-895, August.
    10. Lutz Kilian & Xiaoqing Zhou, 2020. "Does drawing down the US Strategic Petroleum Reserve help stabilize oil prices?," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 35(6), pages 673-691, September.
    11. Juan Antolín-Díaz & Juan F. Rubio-Ramírez, 2018. "Narrative Sign Restrictions for SVARs," American Economic Review, American Economic Association, vol. 108(10), pages 2802-2829, October.
    12. Richard G. Newell and Brian C. Prest, 2019. "The Unconventional Oil Supply Boom: Aggregate Price Response from Microdata," The Energy Journal, International Association for Energy Economics, vol. 0(Number 3).
    13. Lutz Kilian, 2008. "The Economic Effects of Energy Price Shocks," Journal of Economic Literature, American Economic Association, vol. 46(4), pages 871-909, December.
    14. Atsushi Inoue & Lutz Kilian, 2020. "The Role of the Prior in Estimating VAR Models with Sign Restrictions," Working Papers 2030, Federal Reserve Bank of Dallas.
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    21. Christiane Baumeister & James D. Hamilton, 2019. "Structural Interpretation of Vector Autoregressions with Incomplete Identification: Revisiting the Role of Oil Supply and Demand Shocks," American Economic Review, American Economic Association, vol. 109(5), pages 1873-1910, May.
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    23. Diego R. Känzig, 2021. "The Macroeconomic Effects of Oil Supply News: Evidence from OPEC Announcements," American Economic Review, American Economic Association, vol. 111(4), pages 1092-1125, April.
    24. Jamie L. Cross & Bao H. Nguyen & Trung Duc Tran, 2020. "The role of precautionary and speculative demand in the global market for crude oil," CAMA Working Papers 2020-34, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
    25. Lutz Kilian & Bruce Hicks, 2013. "Did Unexpectedly Strong Economic Growth Cause the Oil Price Shock of 2003–2008?," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 32(5), pages 385-394, August.
    26. Kilian, Lutz & Zhou, Xiaoqing, 2018. "Modeling fluctuations in the global demand for commodities," Journal of International Money and Finance, Elsevier, vol. 88(C), pages 54-78.
    27. Lutz Kilian & Daniel P. Murphy, 2014. "The Role Of Inventories And Speculative Trading In The Global Market For Crude Oil," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 29(3), pages 454-478, April.
    28. Hilde C. Bjørnland & Frode Martin Nordvik & Maximilian Rohrer, 2021. "Supply flexibility in the shale patch: Evidence from North Dakota," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 36(3), pages 273-292, April.
    29. Kilian, Lutz, 2019. "Measuring global real economic activity: Do recent critiques hold up to scrutiny?," Economics Letters, Elsevier, vol. 178(C), pages 106-110.
    30. Ana María Herrera & Sandeep Kumar Rangaraju, 2020. "The effect of oil supply shocks on US economic activity: What have we learned?," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 35(2), pages 141-159, March.
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    35. Funashima, Yoshito, 2020. "Global economic activity indexes revisited," Economics Letters, Elsevier, vol. 193(C).
    36. Lutz Kilian & Daniel P. Murphy, 2012. "Why Agnostic Sign Restrictions Are Not Enough: Understanding The Dynamics Of Oil Market Var Models," Journal of the European Economic Association, European Economic Association, vol. 10(5), pages 1166-1188, October.
    37. Adonis Yatchew & Joungyeo Angela No, 2001. "Household Gasoline Demand in Canada," Econometrica, Econometric Society, vol. 69(6), pages 1697-1709, November.
    38. Xiaoqing Zhou, 2020. "Refining the workhorse oil market model," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 35(1), pages 130-140, January.
    39. Jamie L. Cross & Bao H. Nguyen & Trung Duc Tran, 2022. "The role of precautionary and speculative demand in the global market for crude oil," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 37(5), pages 882-895, August.
    40. Braun, Robin, 2021. "The importance of supply and demand for oil prices: evidence from non-Gaussianity," Bank of England working papers 957, Bank of England.
    41. Hilde C. Bjørnland & Frode Martin Nordvik & Maximilian Rohrer, 2021. "Supply flexibility in the shale patch: Evidence from North Dakota," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 36(3), pages 273-292, April.
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    Cited by:

    1. Kilian, Lutz, 2022. "Facts and fiction in oil market modeling," Energy Economics, Elsevier, vol. 110(C).
    2. Storrøsten, Halvor Briseid, 2024. "U.S. light tight oil supply flexibility - A multivariate dynamic model for production and rig activity," Energy Economics, Elsevier, vol. 131(C).
    3. Ron Alquist & Karlye Dilts Stedman & R. Jay Kahn, 2022. "Foreign Reserve Management and U.S. Money Market Liquidity: A Cost of Exorbitant Privilege," Research Working Paper RWP 22-08, Federal Reserve Bank of Kansas City.
    4. M. Adam & O. Bonnet & E. Fize & T. Loisel & M. Rault & L. Wilner, 2023. "How does fuel demand respond to price changes? Quasi-experimental evidence based on high-frequency data," Documents de Travail de l'Insee - INSEE Working Papers 2023-17, Institut National de la Statistique et des Etudes Economiques.
    5. Hong, Yanran & Wang, Lu & Liang, Chao & Umar, Muhammad, 2022. "Impact of financial instability on international crude oil volatility: New sight from a regime-switching framework," Resources Policy, Elsevier, vol. 77(C).
    6. Valenti, Daniele & Bastianin, Andrea & Manera, Matteo, 2023. "A weekly structural VAR model of the US crude oil market," Energy Economics, Elsevier, vol. 121(C).
    7. Jihad El Hokayem & Ibrahim Jamali & Ale Hejase, 2024. "A forecasting model for oil prices using a large set of economic indicators," Journal of Forecasting, John Wiley & Sons, Ltd., vol. 43(5), pages 1615-1624, August.
    8. Wang, Fangzhi & Liao, Hua, 2022. "Unexpected economic growth and oil price shocks," Energy Economics, Elsevier, vol. 116(C).
    9. Lomonosov, Daniil & Polbin, Andrey & Fokin, Nikita, 2020. "Влияние Шоков Мировой Деловой Активности, Предложения Нефти И Спекулятивных Нефтяных Шоков На Экономику Рф [The impact of global economic activity, oil supply and speculative oil shocks on the Russ," MPRA Paper 106019, University Library of Munich, Germany.
    10. Kilian, Lutz & Zhou, Xiaoqing, 2022. "Oil prices, exchange rates and interest rates," Journal of International Money and Finance, Elsevier, vol. 126(C).
    11. Bilgin, Doga & Ellwanger, Reinhard, 2024. "A simple model of global fuel consumption," Energy Economics, Elsevier, vol. 130(C).
    12. Zheng, Xinzhu & Wang, Ranran & Liddle, Brantley & Wen, Yuli & Lin, Lu & Wang, Lining, 2022. "Crude oil footprint in the rapidly changing world and implications from their income and price elasticities," Energy Policy, Elsevier, vol. 169(C).
    13. Daniil Lomonosov & Andrey Polbin & Nikita Fokin, 2021. "The Impact of Global Economic Activity, Oil Supply and Speculative Oil Shocks on the Russian Economy," HSE Economic Journal, National Research University Higher School of Economics, vol. 25(2), pages 227-262.
    14. Puch González, Luis Antonio & Ruiz, Jesús, 2024. "The asymmetry puzzle: the supply chain disruptions news shocks effects on oil prices and inflation," UC3M Working papers. Economics 43758, Universidad Carlos III de Madrid. Departamento de Economía.
    15. Hilde C. Bjørnland & Frode Martin Nordvik & Maximilian Rohrer, 2021. "Supply flexibility in the shale patch: Evidence from North Dakota," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 36(3), pages 273-292, April.
    16. Brandon Schaufele & Jennifer Winter, 2023. "Production Controls in Heavy Oil and Bitumen Markets: Surplus Transfer Due to Alberta’s Curtailment Policy," Energies, MDPI, vol. 16(3), pages 1-24, January.
    17. Herwartz, Helmut & Theilen, Bernd & Wang, Shu, 2024. "Unraveling the structural sources of oil production and their impact on CO2 emissions," Energy Economics, Elsevier, vol. 132(C).
    18. Lutz Kilian, 2023. "How to Construct Monthly VAR Proxies Based on Daily Futures Market Surprises," Working Papers 2310, Federal Reserve Bank of Dallas.
    19. Braun, Robin, 2021. "The importance of supply and demand for oil prices: evidence from non-Gaussianity," Bank of England working papers 957, Bank of England.
    20. Azhgaliyeva, Dina & Kapsalyamova, Zhanna & Mishra, Ranjeeta, 2022. "Oil price shocks and green bonds: An empirical evidence," Energy Economics, Elsevier, vol. 112(C).
    21. Pan, Zhiyuan & Huang, Xiao & Liu, Li & Huang, Juan, 2023. "Geopolitical uncertainty and crude oil volatility: Evidence from oil-importing and oil-exporting countries," Finance Research Letters, Elsevier, vol. 52(C).
    22. Castro, César & Jiménez-Rodríguez, Rebeca, 2024. "The impact of oil shocks on the stock market," Global Finance Journal, Elsevier, vol. 60(C).
    23. Baghish Ahmadov, 2024. "The Impact of Oil Prices on the Import of Capital Goods in Azerbaijan," International Journal of Energy Economics and Policy, Econjournals, vol. 14(3), pages 512-517, May.
    24. Asad Dossani & John Elder, 2024. "Uncertainty and investment: Evidence from domestic oil rigs," Journal of Futures Markets, John Wiley & Sons, Ltd., vol. 44(2), pages 323-340, February.

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    More about this item

    Keywords

    oil supply elasticity; oil demand elasticity; IV estimation; structural VAR; Bayesian inference; oil price; gasoline price;
    All these keywords.

    JEL classification:

    • Q43 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - Energy and the Macroeconomy
    • Q41 - Agricultural and Natural Resource Economics; Environmental and Ecological Economics - - Energy - - - Demand and Supply; Prices
    • C36 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Instrumental Variables (IV) Estimation
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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