Beruflich Dokumente
Kultur Dokumente
Will C. Hambly
December 2, 2005
Economics 272
Professor Studenmund
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Background Information
Being the lifeblood of the world’s industrialized economies, crude oil is the most actively
traded commodity. The world consumes roughly 80 million barrels of crude oil per day and uses
petroleum products for a multitude of applications, including transportation, heating, and plastic
production. Because oil is such an essential input in the production process, its price is closely
followed and reported daily by the financial press. Also, most of the world’s heaviest consumers
of petroleum rely on imports from Middle Eastern oil-producing nations. Since the formation of
the political importance of oil has escalated. In an effort to insulate the American economy from
oil shocks, the U.S. government began stockpiling emergency oil reserves in 1977 as a national
security policy.
The question of whether the price of oil is high or low based on market fundamentals is a
contentious debate. Currently, oil is trading at about $60 per barrel in 2005 dollars, a relatively
high price compared to historical averages. Many justify this price and remain bullish, adhering
to the idea that the supply of petroleum is fixed and that increased demand from developing
countries will drive the price higher as they accelerate growth. Others dismiss the current price
as being irrational and the result of increased speculative activity by large alternative investment
funds. This paper seeks to explain what determines the price of oil.
Several different types of crude oil are produced and receive different market prices. For
instance, North Sea crude, generally known as Brent crude, commands about a $1 premium to
the OPEC Basket Price, which includes various blends of Dubai, Saharan, and Venezuelan
crudes. The price quoted on the New York Mercantile Exchange, however, is for light-sweet, or
West Texas Intermediate (“WTI”) crude. WTI is the most easily and widely refined crude in
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U.S. refineries, making it the most frequently quoted type of oil in the world. Light-sweet WTI
crude on the NYMEX trades at about a $2 premium to the OPEC Basket Crude. Changes in the
price of crude oil have large affects on the U.S. economy and are difficult to explain and predict.
The quoted price of crude oil on the NYMEX represents the cost of one 42-gallon barrel of crude
A careful review of the literature highlights many of the potential drivers behind the price
of crude oil. Both scholarly, commercial, and professional sources described below provide
insight into possible reasons for fluctuations in the price of crude on the NYMEX.
the Journal of Futures Markets, Pindyck shows how short-run price volatility is affected
by levels of inventories held. He also comments that price variation may be the result of
speculation and “herd-behavior”. Pindyck uses a weekly model with price being the
Carlos Coimbra, Senior Economist at the Banco de Portugal, analyzes the demand for
that futures market prices reflect expectations for world economic activity. As economies
and industrial output grow, demand for oil increases. Futures markets should, however,
immediately adjust when actual output is less than what was expected. He notes that it is
very difficult to explain systematic behavior in oil prices. Part of the “errors” in futures
market prices may be related to errors in estimating world economic growth. He uses a
monthly model of the price of nearest expiration futures contracts on the first trading day
of the month.
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Much of the academic literature pertaining to the price of oil surrounds the impact of oil
prices on the macroeconomy. Understanding the Impact of Oil Shocks, published by the
Federal Reserve Bank of St. Louis, examines oil price shocks in the 1970’s and shows
how they contributed to a drop in real GDP and an increase in the price level. This study,
however, analyzes oil prices as an independent variable and does not describe how oil
prices are set; nevertheless it confirms the correlation between economic growth and oil
prices. Another scholarly article, The Cyclical Behavior of NYMEX Energy Prices,
published in Energy Economics, explains that oil prices are procyclical. That is, an
Besides a review of the scholarly literature, relevant commodities articles in both the Wall
Street Journal and the Financial Times offer daily insight into what may be moving the
market. Additionally, information provided by Phil Flynn, an oil trader with Alaron
Trading Co., offered a perspective on fundamental evaluators, such as real GDP, housing
starts, and industrial production. In the interview conducted, he stressed the importance
A Theoretical Model
A review of the literature pertaining to oil prices makes clear that as economic growth
increases, demand for oil increases. The economic theory behind the relationship between
economic growth and oil consumption is strong. In a model seeking to explain changes in price,
there is no question that a measure of demand is necessary. Another important aspect of the oil
market is the role of OPEC, the international petroleum cartel. While OPEC’s role in reducing
petroleum production has diminished over time, the cartel is still likely to have a significant
impact on the price of oil. Additionally, the role of stockpiles of crude oil should have an impact
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on the price of crude. As stocks are depleted, there may be a fear that the commodity is in short
supply and traders will bid up the price. Also, a shock to the production of crude must have an
impact on the price. If there is a significant decline in oil production in a specific area, the
market will likely react to the prospect of reduced availability of oil by bidding up the price.
Lastly, to reflect current trends in the market for crude oil, a time-series model with very frequent
observations should be used. For practical reasons concerning the publishing of economic data,
a monthly model from January of 2002 through June of 2005 will be used.
Additionally, because crude oil on the NYMEX is measured in dollars, inflation must have an
effect on the price of oil. To measure real impacts on the price, inflation must be filtered out of
While it is clear that many variables affect the price of crude oil, determining the correct
variables for an equation is difficult because there are several ways to measure a single
phenomenon. Below are the independent variables and a detailed explanation of why each was
expands and global demand for oil increases. Because the United States economy
consumes roughly 25% of the world’s crude oil, and meticulous monthly data is
collected by the government, the Industrial Production Index was chosen to explain
demand for oil in developed countries. The Industrial Production Index measures the
monthly physical output of the manufacturing, mining, gas, and electricity industries.
Other ways of measuring output, such as real GDP, are inferior to the Industrial
Production Index for this model because real GDP measures output in the service and
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technology sectors, which consume less petroleum than heavy industries. Theory
suggests that the relationship between industrial output and crude prices should be
linear. Increases in industrial output should mean that oil demand has increased and
world economy’s demand for petroleum accelerates. Both China and India are two of
the fastest growing nations and consume large amounts of oil. Almost all literature
concerning the price of oil cites Chinese demand as a driver of prices. The
relationship between non-OECD consumption and the price of oil should be linear as
Change in Crude Stocks: Changes in the commercial stocks of crude oil are an
important driver behind changes in price. Quantities of crude oil stocks are stocks of
oil held at refineries, in pipelines, in bulk terminals, or any quantities in transit to the
aforementioned destinations. If this variable were the absolute level of crude stocks,
an inverse function form would be theoretically accurate, because the impact of the
stock levels on price would diminish as they increased. Because it is the change in
stocks, only linear is appropriate. An increase in crude stocks should ease the
market’s fear of a shortage, so the expected sign of this coefficient is negative (-).
Change in U.S. Field Production: A disruption in U.S. field production should have
a large impact on prices. Because the U.S. consumes more petroleum than it
produces, it is forced to import crude oil from abroad. As more oil is produced in the
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United States, fears of a shortage will diminish and the price should fall. The
relationship between changes in field production and the price of oil should be linear.
Change in OPEC Output: By restricting output, OPEC has been able to raise the
price of oil. OPEC’s share of world oil production has decreased since the 1970’s
because new oil fields have come on-line and market power has eroded; nevertheless,
OPEC’s pricing power still exists. Theory suggests that the relationship between
changes in OPEC output and the price of oil is linear. The expected sign of this
coefficient is negative (-) because as OPEC increases output, the price of oil should
fall.
For this model it is reasonable to assume a functional form in which the equation is linear
in both the coefficients and the variables. Theory does not suggest that the relationship between
the variables described above and the price of oil should be anything other than linear.
description of how the data is expressed, sources, and any irregularities found are offered.
Real Price of NYMEX Crude: Daily data on the price of crude oil is available from
the U.S. Energy Information Administration website. These prices are, however, in
nominal prices. Because there has been persistent inflation throughout the last three
years, prices quoted on the NYMEX were converted to January, 2002 dollars, when
the Consumer Price Index, Less Energy was equal to 186. Each monthly observation
is the real closing price (in January, 2002 dollars) of the contract of nearest expiration
Industrial Production Index: Data was obtained from the Federal Reserve Bank of
St. Louis’ Federal Reserve Economic Data website. This data is seasonally adjusted,
petroleum consumption and economic growth for countries not belonging to the
world production per day per month of crude oil and OECD consumption per day per
month. Because a portion of the oil produced could enter stockpiles, this variable
may not be precise, however the theory behind the idea that developing countries
consume large amounts of oil as they industrialize is very strong, so this variable
same month in the previous year to adjust for seasonality. Data was obtained from
petroleum.
Change in Crude Stocks: Changes in the crude oil stocks are measured as a
percentage change in the quantity of commercial crude oil stocks of the same month
from the previous year to eliminate any seasonal trends. This data is available on the
section.
Change in U.S. Field Production: Data on U.S. field production of crude oil is
variable is calculated as the percentage change in field production from the same
output from the same month of the previous year to eliminate any seasonal patterns.
Statistics on OPEC production are also available from the U.S. Energy Information
Administration.
Using Ordinary Least Squares and the variables discussed above to estimate an equation
Equation 1:
Degrees of Freedom = 36
HO: βINDPROD ≤ 0 tINDPROD = 11.600 | tINDPROD| > tc and the sign is in the correct
HO: βNONOECD ≤ 0 tNONOECD = 0.794 | tNONOECD| < tc even thought the sign is in the
correct direction.
HO: βSTOCKS ≥ 0 tSTOCKS = -2.209 | tSTOCKS| > tc and the sign is in the correct
HO: βFIELDPROD ≥ 0 tFIELDPROD = 0.905 | tFIELDPROD| < tc and the sign is in the wrong
HO: βOPEC ≥ 0 tOPEC = 0.676 | tOPEC| < tc and the sign is in the wrong
direction. Fail to
Reject HO.
Of the five coefficients, two are significant in the expected direction. βINDPROD and βSTOCKS
were significant and in the hypothesized directions. βNONOECD had the expected positive sign,
however it was not significant. βFIELDPROD and βOPEC were insignificant in the unexpected direction.
Of the insignificant coefficients, the economic theory behind βOPEC and βNONOECD is indisputable.
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The impact of OPEC’s output and the developing world’s demand for crude oil is well
documented and strongly supported by economic theory. By reducing output, OPEC is able to
increase the price of oil. Also, as countries not in the OECD, or the world’s developing
countries, industrialize they will increase demand for petroleum products and the price of oil will
After rethinking the theory behind the regression, βFIELDPROD, which was insignificant in
the wrong direction, could be an irrelevant variable. Although there is some theory behind the
idea that as U.S. field production increases, the price of oil should fall, this variable may not
belong because U.S. production is a small fraction of the world total. In fact, increases in field
production may be highly correlated with increases in the price of oil. As the price rises, it
becomes economically viable to drill in harsh environments, therefore increasing the production
of crude oil. In other words, field production does not have a significant impact on the price of
crude oil. The possibility of it being irrelevant must be investigated. It is now dropped from the
Note: See Appendix Equation 2 for Regression Output, Correlation Matrix, Residuals,
and Data.
Hypothesis Tests for Each of the Coefficients in Equation 2:
Degrees of Freedom = 37
HO: βINDPROD ≤ 0 tINDPROD = 11.612 | tINDPROD| > tc and the sign is in the correct
HO: βNONOECD ≤ 0 tNONOECD = 0.737 | tNONOECD| < tc even thought the sign is in the
HO: βSTOCKS ≥ 0 tSTOCKS = -2.139 | tSTOCKS| > tc and the sign is in the correct
HO: βOPEC ≥ 0 tOPEC = 0.702 | tOPEC| < tc and the sign is in the wrong
direction. Fail to
Reject HO.
After re-estimating the equation excluding the suspected irrelevant variable, the four
Theory: The theory behind the idea that U.S. field production affects the price of
crude oil is valid, however the United States only produces a small fraction of the
world’s oil, so this variable may not be belong. Additionally, field production may
not be affecting the price, but the price may be inducing producers to produce more.
Also, U.S. oil supplies may be insulated from periodic disruptions in field production
T-test: The t-score for the coefficient of field production was insignificant in
Equation 1. Two out of the four coefficients became more significant, but only one
became more significant in the expected direction. This is a relatively weak sign that
evidence that that field production is an irrelevant variable and its exclusion is not
Based on the specification criteria, field production is removed from the model. Moving
forward with Equation 2, the equation must be tested to determine if any econometric maladies
afflict it.
Omitted Variables
The equation almost certainly has an omitted variable. A variable for political concern
over future oil supply should be included, however, political tension is not easily quantified. A
dummy variable for political events concerning the oil market would also be appropriate,
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however observations of this variable would indicate that in each month there was a political
event, which would prove useless for the model. Also, since every month has a political event in
the oil market, deciding which event should be considered important injects human error and the
Another possible omitted variable is a gauge of the developing world’s economic growth.
The Non-OECD Consumption of Petroleum variable contains imperfect data. Data on the
developing world’s economic growth or expectations of growth would enhance the accuracy of
Irrelevant Variables
Based on the four specification criteria, the field production variable was eliminated from
the model. The economic theory behind the existing variables is strong and in two of the four
coefficients, it is supported by significant t-scores. Because the variables included are supported
by strong theory, none is irrelevant. The regression results show that βNONOECD and βOPEC have a
very small impact on the price of oil and the coefficients are insignificant. Despite this
Functional Form
There is no reason to suspect that any functional form besides linear in the coefficients as
well as in the variables is appropriate. Including an intercept dummy or slope dummy for
political events may be theoretically appropriate, however, in every month there are several
political events of importance involving oil supply, so determining which events to include
Multicollinearity
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Because the t-scores for βNONOECD and βOPEC are insignificant, and βOPEC has an unexpected
sign, the equation could be afflicted with multicollinearity, which would result in high standard
errors and low t-scores. The Equation 2 Correlation Matrix included in the Appendix shows
All simple correlation coefficients are below 0.80. This is evidence that the equation does not
variance inflation factors is necessary. Computer output for each estimated auxiliary equation
used to compute the VIF is included in the Appendix. Each VIF is presented below:
None of the variables have a variance inflation factor above the threshold of 5. This is
Serial Correlation
Being a time-series model, there is a high probability that the equation may have pure
positive serial correlation. This would bias the estimates of the standard errors negative and
Test requires the appropriate critical values for an equation in which K = 4 and N = 42. These
Because dL ≤ 1.368 ≤ dU, the results of the Durbin-Watson Test are inconclusive. The
existence of positive impure serial correlation cannot be detected. Even though a time series
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model suggests serial correlation, because the Durbin-Watson test is inconclusive no remedy
should be applied.
Heteroskedasticity
Because this is a time-series model and there are not huge differences in size of the
heteroskedasticity could lead to unreliable hypothesis testing because standard errors will be
biased negative, inflating the t-scores, and increasing the probability of a Type I error. The
proportionality factor for this equation. The Industrial Production Index measures the physical
output of U.S. industry, and serves as a measure of the United States’ oil demand. As industrial
output increases, it is reasonable to assume that there may be a higher variance in the price of
crude oil. Thus, the Industrial Production Index is an appropriate proportionality factor.
Running the Park Test requires the generation of three new variables: the squared residuals, the
natural logarithm of the squared residuals, and the natural logarithm of the proportionality factor
Z, which is the Industrial Production Index. These variables are included in the Appendix. An
estimation of the regression to be used in the Park Test is as follows (t-scores in parenthesis):
(1.448)
N = 42 Adjusted-R2 = 0.026
To run two-sided 1% t-test on the estimated coefficient of LNZ, the critical value of 2.704 is
needed.
Results
Of the six major econometric diseases investigated, the only outstanding possibility of a
problem with the equation is the existence of an omitted variable. The quality of the equation
should not be judged by the adjusted-R2 statistic, but being able to explain approximately 88% of
the variation in oil prices with the independent variables used is satisfying. Although βOPEC and
βNONOECD have insignificant coefficients and the sign of βOPEC is in the unexpected direction, the
theory behind these variables commands that they must be included. The tests performed above
also show that the equation is not afflicted with multicollinearity or heteroskedasticity, however
the existence of serial correlation is inconclusive. The final equation (Equation 2) is presented
below:
+ 0.064 OPEC
(0.702)
Note: See Appendix Equation 2 for Data, Regression Output, Residuals, and Correlation
Matrix
The equation shows that industrial output and the change in crude stocks have
significantly large impacts on the price of crude oil traded on the NYMEX. For each one-unit
increase in the Industrial Production Index, the price of crude should rise almost $3, holding all
other independent variables in the equation constant. Also, for each 1% increase in crude stocks
compared to the same month of the previous year, the price of crude should fall nearly $0.17,
holding constant all other variables in the equation. OPEC output and oil consumption in the
developing countries are also likely to be important drivers behind the price of crude, but in this
equation they are insignificant. The model can be used for judging the market’s response to
changes in oil fundamentals, assessing the current price of oil, and creating an oil trading
strategy. Because the financial press devotes thousands of pages each year to covering the price
of oil, the equation above can be used to evaluate analysts’ interpretations of what moves the
market. Further research on possible proxies for political tension should be examined because
political concern is likely to have a positive impact on oil prices. Also, finding more accurate
and extensive monthly data on the developing world’s economic growth would increase the
precision of the model. As the developing world’s economic growth accelerates in the future and
data becomes available, another estimation of the equation with an increased sample size should
Bibliography
Augilar-Conraria, Luis. “Understanding the Impact of Oil Shocks.” Federal Reserve Bank of St.
(1976): 87-107.
Farivar, Maswood. “Crude-Oil Futures Edge Higher As Inventories Post Sharp Drop.” Wall
Goodman, Leah. “Crude Drops Below $57 a Barrel.” Wall Street Journal, 18 Nov. 2005.
Hoyos, Carola. “IEA Urges Calm Over Energy Prices.” Financial Times, 10 Nov. 2005.
McKay, Peter. “Energy Prices Finally Calm Down.” Wall Street Journal, 22 Nov. 2005.
McNutty, Sheila. “US Grapples with The Age of Energy Insecurity.” Financial Times, 21 Nov.
2005.
Padgett, Gary. Great Pacific Trading Company. Personal Interview. 3 Aug. 2005.
Pindyck, Robert. “Volatility and Commodity Price Dynamics.” Journal of Futures Markets 24
(1981): 1029-1047.
Serletis, Apostolos. “The Cyclical Behavior of Monthly NYMEX Energy Prices.” Energy
Studenmund, A.H. Using Econometrics: A Practical Guide. New York: Addison Wesley, 2006.
United States Energy Information Administration. Monthly Energy Review. Nov. 2005.
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United States Energy Information Administration. This Week in Petroleum. Sept-Dec. 2005.
Appendix
Equation 1.
Sources: Energy Information Administration website, Federal Reserve Economic Data website
Equation 2.
Sources: Energy Information Administration website, Federal Reserve Economic Data website