IIES Quarterly Energy Economics Review Vol 4 No 12 SP 2007

Quarterly
Energy Economics Review

Volume 4, Number 12, Spring 2007
Proprietor: Institute for International Energy Studies

Responsible in Charge:
Editor in Chief: Mohammad Mazraati, Ph.D.
Managing Editor: Shohreh Khoshnoudi Nejad
Persian Editor: Raouf Shahsavari
Translater: Alireza Hamidi Younessi
English Editor: Homayoon Nassimi
Art Editor: Latif Rafizadeh
Editoral Board: Hamid Abrishami(Ph.D.)/ Tehran University,

Abolghasem Emamzadeh(Ph.D.)/ Petroleum Industry University,
Ahmad R. Jalali-Naini (Ph.D.)/ Institute for education and
research in management and planning, Mohammad-bagher
Heshmatzadeh (Ph.D.)/ Shahid Beheshti University, Majid
Abbaspour (Ph.D.)/ Azad University, Energy and environment
faculty, Mehdi Assali (Ph.D.)/ Econometrician, OPEC, Morteza
Mohammadi-Ardehali (Ph.D.)/ Amirkabir Industrial University,
Mohammad Mazraati (Ph.D.)/ OPEC, Vienna, A. Shaabani
(Ph.D.)/ Emam Sadegh University, M. H. Zahedivafa (Ph.D.)/
Emam Sadegh University, A. M. Seyf (Ph.D.)/Emam Sadegh
University
Consultants: Ali Emami-Meibodi (Ph.D.), Ebrahim Bagherzadeh
Consultants:
(Ph.D.), Fereidoun Barkeshli (Ph.D.), Ali Geranmayeh (Ph.D.),
Saeed Moshiri (Ph.D.)
Referees: H. Abbasi Nejad (Ph.D.), S. Adibi, M. Amirmoeini, F.
Barkeshli (Ph.D.), M. Behrouzifar, A. Boghosian(Ph.D.), M.
Bozorgzadeh Yazdi, A. Delparish, A. Emamzadeh (Ph.D.), A.
Farzinvash, M.A. Hajimirzaei, M.R. Jalali Naeini(Ph.D.), A.
Kadkhodazade, Sh. Khaleghi, M. Mazraati (Ph.D.), M. Sadeghi
(Ph.D.), D. Vafi Najjar, H. Yadegari
Quarterly Energy Economics Review
Quarterly
Energy Economics Review
Volume 4, Number 12, Spring 2007
CONTENTS
Dynamics of Petroleum Markets in OECD Countries In a 2
Monthly VAR Model
Mehdi Asali
Allocation of CO2 emissions in petroleum refineries to 71
petroleum joint products: a case study
Alireza Tehrani Nejad M. - Valérie Saint-Antonin
Abstracts
Age Estimation of Car Fleet and its Impact on Fuel 101
Consumption in Iran: Efficiency vis-à-vis Renovation
Mohammad Mazraati
Impacts of Oil Price Shocks on Economic Variables in a 103
VAR Model
A. Sarzaeem
Recent Crude Oil Market Developments: Making 104
Structural Models
M. Zamani
A Survey of New Structure of LNG and Natural Gas 106
Industry in the World
E. Mansour Kiaee
INSTITUTE FOR INTERNATIONAL ENERGY STUDIES

P.O. Box: 19395/4757
Tehran, I.R. Iran
Tel: 2202 9351-60
Fax: 22029388
www.iies.org
Vol. 4, No. 12 / Spring 2007 / 1

Dynamics of Petroleum
Markets in OECD Countries
In a Monthly VAR Model
Mehdi Asali1
Abstract
This paper contains results of the first part of a study in which a Vector
Auto-Regression (VAR)/Vector Error Correction (VEC) model is developed
and estimated to investigate dynamics of petroleum markets in OECD. Time
series of the model comprises monthly data for the variables: demand for oil
in OECD, WTI in real term as a benchmark oil price, industrial production in
OECD as a proxy for income and commercial stocks of crude oil and oil
products in OECD for the time period of January 1995 to March 2007. The
detailed results of this empirical research are presented in different sections
of the paper, nevertheless, the general result that emerges from this study
could be summarized as follows: (i) There is convincing evidence of the
series being non-stationary and integrated of order one I(1) with clear signs
of co-integration relations between the series. (ii) The VAR system of the
empirical study appears stable and restore its dynamics as usual following a
shock to the rate of changes of different variables of the model taking
between 5 to 8 periods (months in our case). (iii) It appears that the null
hypothesis of ‘the expected mean of the series being insignificant from
zero’, cannot be rejected in 5% level for each of four time-series indicating
lack of statistical proof for presence of the deterministic trend in time-series
of concern, (iv) Normality tests and histograms of the series reveals that
while distribution of the samples in level differ from theoretical normal
1. Econometrician, PMAD Department, Research Division, OPEC Secretariat, masali@opec.org
2 / Vol. 4, No. 12 / Spring 2007

distribution however this is not the case for the differenced time series and
for the residuals, on the other hand autocorrelation functions of the series are
consistent with unit root process .(v) We find the lag length of 2 as being
optimal for the estimated VAR model. (vi), Significant impact of changes in
the commercial crude and products’ inventory level on oil price and on
demand for oil is highlighted in our empirical study and in different
formulations of the VAR model indicating importance of changes in stocks’
level on oil market dynamics. (vii) Income elasticity of demand for oil
appear to be prominent and statistically significant in most estimated models
of the VAR system, while price elasticity of demand for oil is found to be
negligible and insignificant in the short-run.
Key terms: Petroleum market, dynamics, OECD, VAR model,

stationary.
1. Introduction
Structural changes in petroleum markets and its pricing systems in the
last decades and increasing exposure of the financial markets to
international oil trade have contributed to growing complexity of oil
markets dynamics and volatility of its prices. These complexities are
due to, and in turn intensify, uncertainties surrounding the oil markets
and most often than not undermine robust and accurate prediction of
the oil market developments. Growing demand for energy and oil
particularly in major developing countries with considerable pace,
increasing number of oil producing and exporting nations,
technological changes in` upstream and downstream activities,
integration of oil in the global commodity markets, movements of
open interest in global financial markets on oil trade, impacts of
geopolitical and environmental concerns on petroleum sector and
climate changes are amongst numerous factors effecting oil markets
and its prices. In fact, oil prices have been the most volatile price of all
in commodity markets in recent years.
Because of its significant share in energy mix, which is crucial
for well functioning of every modern society, its important role in the
world economy’s development, and also its exhaustibility, petroleum
Vol. 4, No. 12 / Spring 2007 / 3

markets and its dynamics have always been watched carefully not
only by major consumers and producers but also by economic agents
involved with commodity and financial markets and indeed by the
governments of the producing and consuming nations alike.
Understandably studies related to different aspects of economics of
petroleum have been expanding fast in different directions,
particularly after the oil shocks of 1970s and early 1980s. Turbulences
in oil markets of the late 1990s when oil price reduced drastically due
to the excess supply amid a recession in South East Asian countries,
and continuous upward trend in oil prices on back of persistent tight
markets dominated by growing demand for energy and oil particularly
in major developing countries in last few years, have added yet more
dimensions to dynamics of petroleum sector; further complicating its
analysis.
Although this study is confined to the oil markets in OECD
countries, nevertheless, given this region’s share in the global demand
for oil, investigating developments of petroleum markets in OECD
could contribute to our comprehension of the dynamics of global
petroleum markets. This is a fact that any significant changes in
demand for oil in OECD have always had far-reaching effects on
petroleum markets. Although OECD’s share of global demand for oil
has been continuously declining, due to a fast growing demand for
energy and oil in developing nations; particularly in China, India and
the Middle East, however, in 2006 OECD still was consuming about
60% of global oil supply and according to IEA (2007) OECD will
continue to dominate the oil markets in the foreseeable future with a
55% share of global demand in 2011. The same applies for the crude
and oil products stocks particularly when it comes to commercial
crude and product inventories.
Our study examines relationship between major variables of oil
market in OECD countries for the time period of 1995 to 2007
employing a monthly Vector Auto-regression (VAR)/Vector Error
Correction (VEC) model. The estimated model then is used to forecast
short term demand for oil in OECD. Typically, these relationships are
explored using simple correlation and deterministic trends which in
4 / Vol. 4, No. 12 / Spring 2007

most cases could not yield consistent and robust results. Advantage of
the VAR modeling approach for our purpose in this study over
possible alternative econometric techniques will become clearer as we
proceed further. However, we have briefly pointed out here to the
shortcoming of the traditional econometric models in oil market
analysis.
Fig.Fig
1. 1.
OilOil Consumption in
Consumption in OECD
OECD and
andthe World
the (000
World b/d)b/d)
(000
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0
1970 1975 1980 1985 1990 1995 2000 2005
OIL Consumption OECD

OIL Consumption World
Economic theory suggests existence of equilibrium relationship

between demand for crude oil; income and oil prices. Also economic
theory could have been thought of predicting a meaningful long-run
relationship between inventory of oil and its prices, for oil supply
comprises oil consumption and its inventory and any short run
disequilibrium in oil demand and its supply is usually absorbed by
changes in inventory; hence a close relationship between oil prices
and oil stocks. Although in general the observed pattern of demand for
crude oil, GDP, oil inventory and oil prices tend to support this theory
however, there have been periods in which oil prices, output, oil
Vol. 4, No. 12 / Spring 2007 / 5
demand and inventory have appeared to move independently of each

other.
Now, if one try to explain these relationships by a single
equation structural econometric model, for example as following
linear model:
(1) Dt = α 0 + α1Yt + α 2 Pt + α 3 St + ε t
Where, Dt, Yt , Pt and St are demand for oil, gross domestic
product, oil price and crude and products stocks respectively, there
could be in most part, inadequacy on the part of estimated parameters
due to the fact that important variables of the equation such as the
scale variable of GDP for example, has to be treated as exogenous
factors while in reality these variables are endogenous to the economic
system. One of the major problems with this specification is that GDP
is clearly an endogenous variable, and price may or may not be
endogenous. Given these conditions OLS estimates of α 1 or income
elasticity of demand are poorly defined from econometric point of
view. This leads to application of a variety of econometrics techniques
through which the endogeneity of the variables on the right hand side
of equation (1) could be removed from the equation, and α i can be
properly estimated. Ignoring these facts in modeling oil market
developments would leave the model an inadequate device of data
generating process of oil markets. On the other hand a dynamic
simultaneous equations model will be difficult to identify as economic
theory still is not rich enough to provide a dynamic specification that
identifies all of the restrictions required for such complex
relationships.
However, empirical studies show that time series analysis of oil
market could reveal, if existed, the underlying and lasting relationship
between the important variables of oil market despite apparently
inapprehensible developments in this market. Suppose in our oil
demand equation discussed above, we treated all the variables that we
believed exerted significant impact on oil market dynamics, as
endogenous variables of the system; in this case if the right hand side
variables of equation (1) were assumed endogenous, then we would
6 / Vol. 4, No. 12 / Spring 2007
have needed to formulate explanatory equations for each of these

variables. A VAR can be viewed as a natural extension of the question
of endogeniety and feedback amongst the variables in question. In a
VAR model all variables are treated symmetrically. That is, if we are
interested in demand for oil, GDP, oil price and stocks, then we
should expand our model to a four variable VAR.
A VAR-VEC modeling of petroleum markets would allow us to
investigate the salient features of the economic and statistical
relationship between these variables for the sample period of the study
that covers January 1995 through March 2007. This time period
includes oil price collapse from the supply glut in late 1990s
coincident with economic downturn of many developing countries of
the South-East Asia and sustained oil price increase from 2002 to mid
2006 due to strong global economic performance particularly major
developing countries (e.g. China and India) surge of demand for
energy and oil. So the time period covers sub-periods of both excess
supply and excess demand with their impacts on oil markets
developments.
Nevertheless, the required assumptions, on the basis of which
time-series modeling inferences and forecasts are believed to be valid,
may not hold in every given instance. So the first step in any empirical
analysis using a Vector Auto-Regressive (VAR) or Vector Error
Correction (VEC) model is to test if these assumptions are indeed
appropriate. In the remainder of the paper we first review the main
features of VAR/VEC modeling approaches and then proceed with
estimation and forecasting part of the study. (See appendix for a brief
description on the methodology).
2. A monthly oil market VAR model for OECD

In this section we will develop the VAR model of our study. Studying
demand for oil, similar to other commodities, immediately postulate
presence of income and price in the model. However, in congruity
with the literature (see for example M. Ye, et. al.(2002)), as discussed
earlier, we recognize the significant effect of oil inventory (crude and
Vol. 4, No. 12 / Spring 2007 / 7

products) on dynamics of oil markets, i.e. on oil price and through this
variable on demand for oil, thus in this study, our specification of the
four variable VAR model takes in account the effects of oil stock
changes on oil market developments. This is also important to note
that WTI in our VAR is in real term. In other words nominal oil price
is deflated by OECD consumer price index. One can find many
examples of VAR models of oil market treating oil price in real terms
(see for example R. Jimenez-Rodrigues and Marcelo Sanches, 2004).
In fact in this version of the VAR model we are mainly interested in
oil demand in OECD, which is suppose to be a function of real oil
price, rather than impacts of nominal oil price shocks on inflation and
economic activities in his region. In a next attempt we will extend the
VAR model to consider nominal oil prices and other variables as well.
This would be interested to compare the results of this version of the
VAR model with one where impacts of oil price on inflation and
economic growth are examined. The VAR model of four variables in
our study in its most general structure could be introduced as follows:
k k k k
Dt = α1 + ∑ β1i Dt −i + ∑ β 2iYt −i + ∑ β 3i Pt −i + ∑ β 4i St −i +ε 1t
i =1 i =1 i =1 i =1
k k k k
(2) Yt = α 2 + ∑ β 5i Dt −i + ∑ β 6iYt −i + ∑ β 7 i Pt −i + ∑ β 8i St −i +ε 2t
i =1 i =1 i =1 i =1
k k k k
Pt = α 3 + ∑ β 9i Dt −i + ∑ β10iYt −i + ∑ β11i Pt −i + ∑ β12i St −i +ε 3t
i =1 i =1 i =1 i =1
k k k k
St = α 4 + ∑ β13i Dt −i + ∑ β14iYt −i + ∑ β15i Pt −i + ∑ β16i St −i + ε 4i
i =1 i =1 i =1 i =1
Where, as defined before, Dt, Yt, Pt and St stands for Demand for
oil in OECD, an index of monthly industrial production in OECD,
WTI benchmark oil prices and oil stock (crude and product) in OECD
countries at time t and respectively. Coefficients of the model “ β i ”
and intercepts α i are to be estimated.
2.1 Time series properties of the VAR model variables

A simple graphical and statistical analysis would enhance our
8 / Vol. 4, No. 12 / Spring 2007

comprehension of the VAR system of concern. Using 12 years of

monthly data drawn from January 1995 to March 2007, time series of
demand for oil, industrial production and oil and crude commercial
stocks in OECD and WTI prices in real terms are analyzed, focusing
on short-run effects of changes in these variables on the system of
time-series. Monthly time-series were used because they have
sufficient characteristics to capture short-run movements of the
variables of concern over time, without adding unnecessary
complexity to the analysis. This is relevant to the monthly analysis
and forecast of oil market developments in OPEC monthly reports.
Entire data is collected from Data Service Department (DSD) of the
OPEC Secretariat
The statistical and graphical analysis of the time-series of the
VAR system consists of inspecting the levels and differences of the
variables. The logarithmic transformation of series used to remove the
scale effects in the variables and reduce the possible effect of
heterokedasticity. This transformation also allows the estimated
coefficients to be interpreted as constant elasticities and circumvent
the problem of different units of the time series.
Table (1) reports some descriptive statistics for the logarithms of
the variables in levels, differences and for the residuals. Since the
variables appear to be non-stationary in level, the empirical density of
distributions of the variables as were depicted in Figure (5) below do
not seem to be normal. The differences of the variables, which
indicate changes to these variables on the other hand, seem stationary
around a constant mean. From table (1), the mean for differences of all
four variables of the model is not significantly different from zero,
(with largest value being around 0.005 for ∆P = ∆ WTI[ CPI
]).
Normality is tested with Jarque-Bera test, distributed as χ 2 (2)
under the null. Jarque-Bera is a test statistic for testing whether the
series is normally distributed. The test statistic measures the difference
of the skewness and kurtosis of the series with those from the normal
distribution. The statistic is computed as:
Vol. 4, No. 12 / Spring 2007 / 9

N 2 ( K − 3) 2
(3) J −B= [S + ]
6 4
Where S is the skewness, and K is the kurtosis (see: Eviews, 6,
2007). Under the null hypothesis of a normal distribution, the Jarque-
Bera statistic is distributed as χ 2 with 2 degree of freedom. The
reported Probability is the probability that a Jarque-Bera statistic
exceeds (in absolute value) the observed value under the null
hypothesis- a small probability value leads to the rejection of the null
hypothesis of normal distribution. So for example if in a test of
normality J-B statistic’s probability was reported to be about 0.04 we
could say the hypothesis of normal distribution is rejected in 5% but
not at the 1% significant level. In estimated VAR model, the J-B test
statistic is a multivariate extension of the test, which compare the third
and fourth moments of the residuals to those from normal distribution.
Usually Doornik and Hansen (1994) approach to normality test is
adopted.
From table (1) we can see that, probability of the normality of
the distributions of variables in first difference and also the VAR
residual is higher than that of the variables in level. This is also
evident from visual inspection of the histograms of the model’s
variables in level and first difference.
Generally speaking we cannot reject normality of these variables
in difference and residuals of the VAR model except for variable
LTSOECD- stock of crude and products in OECD. The test provides
normality of distribution of this variable in level form. Since the
normality test, along with AR and ARCH tests is usually considered a
test of mis-specification, so having found evidence of the residuals of
the VAR model being derived from normal distribution is encouraging
on the basis that this is an indication of proper specification of the
model.
While it is difficult to discern if a time-series is nonstationary by
visual examination of level data, however, it is always a good idea to
start with a visual inspection of the data and their time series
10 / Vol. 4, No. 12 / Spring 2007

properties as a first check of the assumptions of the VAR model.

Based on the graphs we can get a first impression of whether xi ,t
looks stationary with constant mean and variance, or whether this is
the case for ∆xi ,t . If the answer is negative to the first but positive to
the next one, we can solve the problem by re-specifying the VAR in
error-correction form as will be illustrated in the following sections of
the paper.
Table 1. Descriptive statistics of the VARModel Variables
........................................D...............Y .............P ∗ ...............S ...............∆D...............∆Y ..........

_________________________________________________________________________
Mean...........................10.77........4.56......... − 1.28..........14.76.........0.001...........0.002.........
Median........................10.77.........4.58........ − 1.32..........14.77..........0.003..........0.002...........
Maximum....................10.85.........4.70........ − 0.4............14.84..........0.062..........0.014.......
Minimum.....................10.65.........4.41........ − 2.2............14.68....... − 0.09......... − 0.01......
Std .Dev..........................0.04.........0.078.........0.37............0.03..........0.03.............0.002.......
Skewness.................... − 0.43..... − 0.31............0.35......... − 0.17...... − 0.35.......... − 0.28......
Kurtosis.........................3.02........2.23............2.83.............2.76.........2.95.............2.95.......
Jarque − Bera................4.46.........5.56............3.1..............1.09.........2.98.............1.9...........
Pr obability....................0.10.........0.05............0.20............0.58.........0.22.............0.37........
Sum.Sq..Dev...................0.22.........0.86..........19.54............0.17.........0.14.............0.002.....
__________________________________________________________________________
.......................................∆P.............∆S ..............εˆD ................εˆY ...............εˆP ..............εˆS ...
__________________________________________________________________________
Mean............................0.005........0.0002.........0.0.............0.0.............0.0.............0.0.......
Median.........................0.013........0.002...........0.001.........0.0002.... − 0.005.........0.001.....
Maximum.....................0.198........0.038...........0.07...........0.011.........0.180.........0.039.....
Minimum.................... − 0.20...... − 0.06......... − 0.06...........0.010....... − 0.195..... − 0.05.....
Std .Dev..........................0.07.........0.015..........0.025..........0.004.........0.068.........0.01.........
Skewness.................... − 0.24...... − 0.52............0.04......... − 0.195...... − 0.15....... − 0.41......
Kurtosis.........................2.88.........3.64............3.14............2.65............3.06.........4.01......
Jarque − Bera.................1.5..........8.9...............0.16............1.61............0.57.........9.93....
Pr obability.....................0.46........0.01.............0.92............0.44............0.75.........0.01......
Sum.Sq.Dev.....................0.78........0.03.............0.09............0.002..........0.65.........0.03....
___________________________________________________________________________
(*)..P = WTI[ CPI
, ]
___________________________________________________________________________
Vol. 4, No. 12 / Spring 2007 / 11

If in rare cases we found answers to both questions negative, it

would be wise to investigate whether any significant departure from
the constant mean and constant variance coincides with specific
economic reforms or intervention at specific date in the time period of
concerned. The next step in this case would be inclusion of this
information in the model to find out about the intervention has had a
permanent or transitory characteristic or whether it appear to be
additive to the model or has fundamentally changed the parameters of
the model. In the latter case the intervention is likely to have caused a
regime shift and the model would need to be re-specified allowing for
the appropriate change in the structure (see: Juselius, 2003).
Inspecting the graphs of the level of time series of our VAR
model in different panels of Figure (2) suggested existence of non-
stationary processes in the model while visual study of first
differenced based graphs of the model variables do not indicate non-
stationarity. Graphs of Figure (3) illustrate that these type of stochastic
process are capable to adequately describe the data, independently of
whether one takes a close-up or a long-distance look at the time series.
Figure (4) presents WTI in real term in first differences and 12-
month differences respectively. Both series appear stationary in their
differences although it seems that the departure from the mean appear
more prolonged in monthly difference case. Also the outliers appear to
be present in both cases. These might cause non-stationarity in an
stable time-series system.
A visual inspection reveals that, apart from significant volatility
of the processes in the level and the differenced cases, which is a
reflection of the magnitude of changes to the level of the variables,
neither the assumption of a constant mean or a constant variance seem
appropriate for the levels of the time-series, whereas the differenced
time-series look more satisfactory in this respect. If marginal
processes are normal then the observations should lie systematically
on both sides of the mean. This seems approximately to be the case
for real WTI but for oil stock and to some extend for industrial
production there are some outlier around year 2000. This is a good
12 / Vol. 4, No. 12 / Spring 2007

idea to find out whether the outlier observations can be related to

some significant economic developments including economic or
energy policy intervention in OECD level or whether these
observations are too far away from the mean to be considered
realizations from a normal distribution.
Fig. 3 Differences of the Model's Time-series

Fig. 2. Differences of the Model's Time-series
.08 .3
.2
.04
.1
.00
.0
-.04
-.1
-.08 -.2
-.12 -.3
1996 1998 2000 2002 2004 2006 1996 1998 2000 2002 2004 2006
a. Difference of (Log of) Monthly Demand for Oil OECD b. Difference of (Log of) Real WTI
.015 .04
.010 .02
.005
.00
.000
-.02
-.005
-.04
-.010
-.015 -.06
1996 1998 2000 2002 2004 2006 1996 1998 2000 2002 2004 2006
c. Difference of (Log of) Industrial Production Index OECD d. Difference of (Log of) Total Commercial Stock OECD
As was mentioned before, there seem to be some outlier

observations, which apart from the series in level, this seems to be the
case both in the differenced time-series and the residuals. As it is well
known an outlier in a regression is a data point which has a large
residual. Large in this context does not refer to the absolute size of a
Vol. 4, No. 12 / Spring 2007 / 13

residual but to its size relative to most of the other residuals in the
regression. Some of most outstanding outliers for WTI series appear
to be around year 2000, 2001 and 2005. The Katrina hurricane in July
2005 in Golf of Mexico and the South East of the USA appears to be
the reason behind price violation of mid 2005 reflected in the time
series residuals.
Fig.Fig.4
3. WTI
WTIPrices:
Prices: Firstand 12-Month
First and 12-Month Difference
Difference in Logarithms
in Logarithms
-1
Prices Changes (in Logarithms)
-2
-3
1996 1998 2000 2002 2004 2006
1-Month Difference (WTI)
-1
-2
-3
1996 1998 2000 2002 2004 2006
12-Month Differenc (WTI)
14 / Vol. 4, No. 12 / Spring 2007

As was mentioned before, there seem to be some outlier

observations, which apart from the series in level, this seems to be the
case both in the differenced time-series and the residuals. As it is well
known an outlier in a regression is a data point which has a large
residual. Large in this context does not refer to the absolute size of a
residual but to its size relative to most of the other residuals in the
regression. Some of most outstanding outliers for WTI series appear
to be around year 2000, 2001 and 2005. The Katrina hurricane in July
2005 in Golf of Mexico and the South East of the USA appears to be
the reason behind price violation of mid 2005 reflected in the time
series residuals.
Fig. 4. The graphs of the residuals from the VAR model

Fig. 4.The graphs of the residuals from the VAR model
LDOECD Residuals LIPIOECD Residuals
.08 .012
.008
.04
.004
.00 .000
-.004
-.04
-.008
-.08 -.012
1996 1998 2000 2002 2004 2006 1996 1998 2000 2002 2004 2006
LRWTI Residuals LTSOECD Residuals

.2 .06
.04
.1
.02
.0 .00
-.02
-.1
-.04
-.2 -.06
1996 1998 2000 2002 2004 2006 1996 1998 2000 2002 2004 2006
Vol. 4, No. 12 / Spring 2007 / 15

Fig. 5 Histograms and Autocorrelation Functions of the Series

Fig. 5. Histograms and Autocorrelation Functions of the Series
LDOECD LIPIOECD
16 12
10
12
8
Density
Density
8 6
4
4
2
0 0
10.60 10.65 10.70 10.75 10.80 10.85 10.90 4.3 4.4 4.5 4.6 4.7
LRWTI LTSOECD
2.0 16
1.6
12
1.2
Density
Density
8
0.8
4
0.4
0.0 0
-2.5 -2.0 -1.5 -1.0 -0.5 0.0 14.64 14.68 14.72 14.76 14.80 14.84 14.88
Histogram Kernel Normal
LIPIOECD
1.0
LDOECD
A u to c o rre la tio n
0.8
.8
0.6
A u to co rre latio n
.6
0.4
.4
0.2
.2
2 4 6 8 10 12 14 16 18 20 22 24
.0 Actual Theoretical
2 4 6 8 10 12 14 16 18 20 22 24
Actual Theoretical
LRWTI LTSOECD
1.0 1.0
0.8
A u to c o r re la tio n
0.5
0.6
0.4
0.0
0.2
0.0
-0.5
2 4 6 8 10 12 14 16 18 20 22 24
2 4 6 8 10 12 14 16 18 20 22 24
Actual Theoretical
Actual Theoretical
16 / Vol. 4, No. 12 / Spring 2007

Fig. 6. Histograms and Autocorrelation of the First Differences

Fig. 6 Histograms and Autocorrelation of the
of
Firstthe Seriesof the Series
Differences
DLDOECD DLIPIOECD
20 120
100
16
80
12
Density
Density
60
8
40
4
20
0 0
-.12 -.08 -.04 .00 .04 .08 .12 -.02 -.01 .00 .01 .02
DLRWTI DLTSOECD
7 40
6
30
5
4
Density
Density
20
3
2
10
1
0 0
-.3 -.2 -.1 .0 .1 .2 .3 -.08 -.04 .00 .04 .08
DLDOECD
DLIPIOECD
.6
.4
.4
Autocorrelation
.3
Autocorrelation
.2 .2
.1
.0
.0
-.2
-.1
-.4 -.2
2 4 6 8 10 12 14 16 18 20 22 24 2 4 6 8 10 12 14 16 18 20 22 24
Actual Theoretical Actual Theoretical
DLRWTI
DLTSOECD
.2
.4
.1
.2
.0
.0
-.1
-.2 -.2
-.3 -.4
2 4 6 8 10 12 14 16 18 20 22 24 2 4 6 8 10 12 14 16 18 20 22 24
Actual Theoretical Actual Theoretical
Vol. 4, No. 12 / Spring 2007 / 17

It appears that all four time series of the VAR model are
integrated of order one or in other word first differences of these
process are stationary which will be investigated along with other
statistical properties of the model in the next sections. The probability
distribution and autocorrelation functions (ACF) for the level and first
differences of the series are presented in figures (5) and (6).
Histograms summarize the frequency of occurrence that a variable
falls within a certain range of values. As such, histograms provide
insights into the mean, standard error and probability distribution of
given variable. Histograms of the demand for oil (D=LDOECD) and
Industrial production Index (Y=LIPIOECD) in OECD, and histograms
of (P=WTI) bench mark oil prices and total commercial stock
(S=LTSOECD) are presented in the top panel of Figure (5) and Figure
(6) respectively, with a plot of nominal distribution superimposed over
the histogram and a smooth line generated from the histogram.
It is apparent that none of the time series in level distributed
normally, hence the variables are skewed differently relative to the
normal distribution. The ACFs through 24 lags of the variables are
presented in the lower panel of the figures. The ACFs are highly
significant. The wavy cyclical correlogram with a seasonal frequency
for demand for oil and also commercial stocks suggest a seasonal
pattern for these variables. These graphical and statistical finding are
consistent with unit root processes.
Panels of Figure (6) depict histogram and ACFs for the first
differences of all the variables of the model. In each case, the
differencing transformation appears to have resolved the non-
stationarities in the four series for the most parts. In all cases, the
probability distributions of the differenced series appear to be
approximately normally distributed. Further, the autocorrelations are
also much smaller, and statistically insignificant at most lags. These
results lend support to the inference that the time series of our
VAR/VEC model are unit roots in level and integrated processes of
order one, I(1).
Therefore the problems associated with non-stationary data will
be a key consideration in the model specification and estimation that
follows.
18 / Vol. 4, No. 12 / Spring 2007

Fig. 7. The Empirical and Normal Density of the Four VAR Residuals
Fig. 14 The Empirical and Normal Density of the Four VAR
Residuals
RESIDUALS LIPIOECD
RESIDUALS LDOECD
25 120
100
20
80
15
Density
Density
60
10
40
5
20
0 0
-.10 -.05 .00 .05 .10 -.02 -.01 .00 .01 .02
RESIDUALS LRWTI RESIDUALS LTSOECD

10 50
8 40
6 30
Density
Density
4 20
2 10
0 0
-.3 -.2 -.1 .0 .1 .2 .3 -.08 -.04 .00 .04 .08
In Figure below, the histograms and auto-correlograms are

reported for four VAR residuals. There should be no significant
autocorrelation, if the truncation after the second lag is appropriate.
Since all the autocorrelations are quite small, this seems to be the case.
As discussed earlier the presence of auto-correlation in the residuals of
the estimated model is often a result of model misspecification rather
than ‘genuine’ auto-correlation of the model error terms. Recall that
formal tests of the properties of the error term are carried out on the
residuals. But, whilst the errors are a part of the data generation
process, the residuals are a product of our model specification
(Mukherjee et al, 1998). Hence testing for autocorrelation should in
the first instance be interpreted as a test for misspecification. The
classical linear regression model assumes lack of serial correlation
between the error terms, i.e a zero covariance between the error terms
of different observation. In other words, it assumes that because the
Vol. 4, No. 12 / Spring 2007 / 19
error for one observation is large this dose not mean that the next error
term also will be large. Indeed, the fact that an term is positive should
have no implications for whether the next term is positive or negative.
Fig. 8. Autocorrelogram of the Four VAR Residuals
Fig. 15 Autocorrelogram of the Four VAR Residuals
.8 .8
.4 .4
.0 .0
-.4 -.4
-.8 -.8
2 4 6 8 10 12 14 2 4 6 8 10 12 14
Correlogram Residual LDOECD Correlogram Residual LIPIOECD
.8 .8
.4 .4
.0 .0
-.4 -.4
-.8 -.8
2 4 6 8 10 12 14 2 4 6 8 10 12 14
Correlogram Residual LRWTI Correlogram Residual LTSOECD
To understand the implication of auto correlation for residual plots

observe that if the different (residual) terms are independent then we
should not see any patterns in the data- for example, there should not
be long runs of positives followed by long runs of negatives, when a
run is defined as successive values of the same sign. Eventually, a
positive value in on period should not imply a negative value in the
following period, so the plot should not be exceptionally jagged (i.e.
have many short runs of positive and negative values). Also we
realize that the empirical density functions are not deviated too much
from the normal density and the residuals seem homo-scedastic, i.e.
have similar variances over time. A couple of empirical densities,
(LDOECD and LIPIOECD) seem to have longer tails (excess
kurtosis), that are likely to be influenced by poor economic
performance of 2000 to 2002 causing non-normality of these time
series as pointed out earlier.
20 / Vol. 4, No. 12 / Spring 2007

2.2 The statistical adequacy of the model

To comprehend when a VAR is an adequate description of reality, it
is important to know the limitations as well as potentials of that
model. It was briefly mentioned that a VAR model can be a
convenient way of summarizing the information given by the
autocovariances of the time series data under certain assumptions
about the data generating process (DGP) (Hendry, 1995a). However,
the required assumptions may not hold in any given instance, so the
first step in any empirical analysis of a VAR model is to test if these
assumptions are indeed appropriate.
We could write our VAR system in a more compact manner as
follows:
k
( 4) X t = ΦDt + ∑ Π i X t −i + ε t ............ε t ~ IN p [0, Ω ε ]
i =1
Where X is a vector of variables, i.e. X=[D, Y, P, S] and Π is a

vector of parameters, Π = [ β j1, ..., β j ,k ],... j = 1,...., m 2 m being the
number of the variables of the model . t=1,…,T and the parameters
( Dt , Π i , Ω ε ) are constant and unrestricted, except for Ω ε being
positive-definite and symmetric.
Given (3), the conditional mean of Xt is:
k
(5) E[ X t X t −i ] = ΦDt + ∑ Π i X t −i = Xˆ t ,.
i =1
And the deviation of Xt defines ε t as:

X t − Xˆ t = ε t
Hence, if the assumptions of multivariate normality, time-
constant covariance, and the lag structure of the VAR are correct, then
system (3):
i) is linear in the parameters;
ii) has constant parameters;
iii) has normally distributed errors ε t , with:
iv) independence between ε t and ε t − h ,....h = 1,2,...
These conditions provide the model builder with testable
Vol. 4, No. 12 / Spring 2007 / 21
hypothesis on the assumptions needed to justify the VAR (see:

Hendry, 1995). In economic applications however, the multivariate
normality assumption is seldom satisfied. This is potentially a serious
problem, since derivation of a general DGP rely heavily on
multivariate normality, and statistical inference is only valid to the
extent that the assumptions of the underlying model are correct,
(Hendry and Juselius, 2000). An important question is, therefore, how
we should modify the standard general VAR model (2) in practice.
We would like to preserve its attractiveness as a reasonably tractable
description of the basic characteristics of the data, while at the same
time, achieving valid inference. Thus it seems advisable to ensure
validity of the first three assumptions. It is often useful to calculate
descriptive statistics combined with a graphical inspection of the
residuals as a first check of adequacy of the VAR model, as we did
above, and then undertake formal mis-specification tests of each key
assumption, that we are about to do in next sections of the paper. Once
we understand why a model fails to satisfy the assumptions we can
often modify it to end with a well-behaved model.
2.3 A Tentatively unrestricted VAR (2)

As a first step in the analysis, an unrestricted VAR(2) version of the
model with a constant term and without dummy variables is estimated
for the all four variables.
Observe that under the assumption that the parameters
Θ = {Π 1 , Π 2 ,......, Π k , Ω} in the VAR model (3) above are
unrestricted, OLS estimator will be identical to Full Information
Maximum Likelihood (FIML) estimator (see Hendry, 1995 and
Juselius, 2003). However, when the data contain unit-roots we need to
derive the likelihood estimator subject to reduced rank restriction.
This will be discussed later but in this part of the paper, given the
assumptions just mentioned we will conduct estimation of an
unrestricted VAR (2) model of the system of time-series of concern to
use in our analysis of oil market dynamics in OECD countries. The
estimation results of our unrestricted VAR(2) model, i.e:
22 / Vol. 4, No. 12 / Spring 2007

( 6) X t = ΦDt + Π 1 X t −1 + Π 2 X t −2 + ε t
t = 1,...., T , and ..ε t ~ N p (0, Ω)
where Dt contains constant values, are reported below. An
inspection of the estimated coefficients reveals more significant
coefficients at lag 1 than lag 2. Also we realize that most of the
coefficients with large t-ratios are on the diagonal, implying a highly
autoregressive character of the variables. Also the significance of the
crude and product stocks in oil demand and oil price equations is
worth noting. These results support our earlier remark on the
importance of the crude and product stocks for oil price and oil
demand.
..............................The.Estimated.Model. X t = ΦD + Π 1 X t −1 + Π 2 X t − 2 + ε t
________________________________________________________________________
 Dt  2.12  0.60 .. − 0.03......0.50 ......0.82   Dt −1 
∗ ∗
 P  6.8    
 + − 0.25......1.05 . − 1.93 ....1.4   Pt −1  +
∗ ∗
(7 )  t =
 S t  2.67 ∗  − 0.13∗.....0.01......0.83∗.. − 0.39   S t −1 
      
Yt  − 0.24  0.001.. − 0.02 ... − 0.002....0.94  Yt −1 
∗ ∗
− 0.02........0.03... − 0.4 ∗.... − 0.67   D1− 2  ε 1,t 

    
− 0.23..... − 0.10......1.7 ..... − 0.99  Pt − 2  + ε 2,t 
∗
0.02......... − 0.01.......0.05......0.45   S t − 2  ε 3,t 

    
0.003..........0.02 ∗......0.02......0.04  Yt − 2  ε 4,t 
1.0  0.00066
0.109......1.0   
Ω= ,..σˆ ε = 0.00502
0.051......0.26.......1.0  0.00022
   
0.76........0.086.......0.096......1.0 0.00002
Statistics.. for.individual.. var iables.......D.................P...............S .............Y

R 2 .........................................................0.60............0.96..........0.82.......0.99
Adj − R 2 ...............................................0.59............0.96..........0.81........0.99
F − statisic..........................................25.90........478.73........79.37...4716.70
Common.sample.statistics,. Akaik.Information.Criterion( AIC ), and .Schwartz.Criterion( SC )

ˆ = −32.86,.. AIC = −21, ,.SC = −20
Log ( L max) = 1534.9,..... log Ω
________________________________________________________________________
Vol. 4, No. 12 / Spring 2007 / 23

As mentioned above these estimates are ML estimates as long as

no restrictions have been imposed on the VAR model. To increase
readability we have omitted standard errors of estimates and “t” ratios.
Instead, coefficients with a “t”-ratio greater than 1.70 have been given
an asterisk indicating statistical significance (at 5% level) of these
parameters in the model. For the reason that will be discussed below
related to the existence of unit-root in the system and since Xt is not
likely to be stationary. In this case the “t” ratios are more likely to be
distributed as the Dickey-Fuller’s “τ” (Juselius, 2003) and should,
therefore, be interpreted as Student’s t.
It is obvious that a typical VAR model will be greatly over
parameterized, in the sense that many of the coefficients (especially in
a VAR that has lag length greater than one) will be individually
insignificant. Our VAR model is no exemption. For example in our
small VAR model of oil market, assuming only two lag length for the
model, we will have 32 (m2×k) of β parameters to estimate where m is
the number of endogenous variables in the system.
It should be noted that, in a standard VAR model, the right hand
side contains only pre-determined variables (mostly lagged ones) and
the disturbance terms are assumed to be serially uncorrelated. Thus,
each equation of the VAR system can be estimated by ordinary least
square without loss of efficiency (Atkins, 2005).
Dynamics of the VAR(2) unrestricted model depicted in this
graphs, seem to be in accordance with our expectations of the oil
markets and prediction of economic theory. An increase in oil price
reduces oil demand while on the other hand an increase on oil demand
has an positive impact on oil prices. A positive shock on economic
activities increases demand for oil and an increase of demand for oil
decreases the level of crude and product stocks which later rebound
back to its initial level.
While the unrestricted estimated VAR model’s behavior seems
plausible in an economic sense, this is still advisable to remind
ourselves, briefly, of the exact interpretation of the VAR models
before proceeding further with our analysis of oil market dynamics
exhibited in different representations of the VAR-VEC models. This
24 / Vol. 4, No. 12 / Spring 2007

will give us the necessary justification for addressing the non-

stationarity issue of the series of our VAR system for some
specification of the model even in price of losing information
pertaining to the long-run relationships between the variables.
Fig. 9.a. Fig.
Monthly
10.a Dem andDemand
Monthly for Oil infor
OECD
Oil inFitted
OECD, Values and
Fitted Values and Residuals
Residuals 10.84
10.80
10.76
.03 10.72
.02
10.68
.01
.00
-.01
-.02
-.03
95 96 97 98 99 00 01 02 03 04 05 06
Res idual A c tual Fitted
Fig. 9.b. Real WTI Fitted values and Residuals

Fig. 10.b Real WTI, Fitted values and Residuals
-0.4
-0.8
-1.2
.3 -1.6
.2 -2.0
.1 -2.4
.0
-.1
-.2
95 96 97 98 99 00 01 02 03 04 05 06
Res idual Ac tual Fitted
Fig.Fig.
9.c.10.c
Commerclal Stocks of Crude and Products. Fitted
Commercial Stocks of Crude and Products,
values and Residuals
Fitted values and Residuals
14.84
14.80
14.76
.06
14.72
.04
.02 14.68
.00
-.02
-.04
-.06
95 96 97 98 99 00 01 02 03 04 05 06
Res idual Ac tual Fitted
Vol. 4, No. 12 / Spring 2007 / 25

Fig. 9.d. Industrial Production Index, Fitted Values and Residuals

Fig. 10.d Industrial Production Index, Fitted
Values and Residuals
4.8
4.7
4.6
.015 4.5
.010
4.4
.005
.000
-.005
-.010
-.015
95 96 97 98 99 00 01 02 03 04 05 06
Res idual A ctual Fitted
Fig. 10. Response to Cholesky One S.D. Innovations ±2 S.E.

Fig. 5 Response to Cholesky One S.D. Innovations ± 2 S.E.
in the Model in the(20)
Model (20)
Response of LD to LP Response of LD to LY
.03 .03
.02 .02
.01 .01
.00 .00
-.01 -.01
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Response of LP to LS Response of LP to LD
.100 .100
.075 .075
.050 .050
.025 .025
.000 .000
-.025 -.025
-.050 -.050
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Response of LS to LD Response of LP to LY
.100
.02
.075
.01
.050
.025
.00
.000
-.01
-.025
-.050
-.02
1 2 3 4 5 6 7 8 9 10
1 2 3 4 5 6 7 8 9 10
26 / Vol. 4, No. 12 / Spring 2007

2.4 Economic interpretation of the VAR models

The Vector Autocorrelation (VAR) process based on Gaussian errors
has frequently been a popular choice as a description of economic
time series data. There are many reasons for this: the VAR model is
flexible, easy to estimate, and it usually gives a good fit to economic
data. However, the possibility of combining long run and short run
information in the data by exploiting the co-integration property is
probably the most important reason why the VAR model continuous
to receive the interest of both economists and econometricians
(Juselius, 2003).
Theory based economic models have traditionally been
developed as non-stochastic mathematical entities and applied to
empirical data by adding a stochastic error process to the
mathematical model. However, from an econometric point of view the
two approaches are quite different: one starting from an explicit
stochastic formulation of all data and then reducing the general
statistical dynamic model by imposing testable restrictions on the
parameters, the other starting from a mathematical formulation of a
theoretical model and then expanding the model by adding stochastic
components.
As discussed in Hendry (1995a), the conditional mean of a VAR
model can be given an econometric interpretation as the agents’ plan
at time t-1 given the past information of the process (derived from of
the lagged variables) of the model. The assumptions in (19)
concerning the residuals of the model being independent and normally
distributed implies that the market players are rational, in the sense
that the deviation between the actual outcome Xt and the plan
E t −1[ X t X t0−1 ] is a white noise innovation, not explicable by the past of
the process. Thus the VAR model is consistent with economic agents
who seek to avoid systematic forecast errors when they plan for time t
based on the information available at time t-1. On the contrary, a VAR
with auto-correlated residuals would describe agents that do not use
all information in the data as efficiently as possible. This is because
they could do better by including the systematic variation left in the
Vol. 4, No. 12 / Spring 2007 / 27
residuals, thereby improving the accuracy of their expectations about

the future. Therefore, checking assumptions of the model is not only
crucial for correct statistical inference, but also for the economic
interpretation of the model as a description of the behavior of rational
agents.
To derive a full-information maximum likelihood (FILM)
estimator requires an explicit probability formulation of the model.
Doing so has the advantage of forcing us to take the statistical
assumptions seriously. Suppose that we have derived an estimator
under the assumption of multivariate normality. We then estimate the
model and find that the residuals are not normally distributed, or that
residual variance is heteroscedatic instead of homoscedastic, or that
residuals exhibit significant autocorrelation, etc. The parameter
estimate may not have any meaning, and since we do not know their
‘true’ properties, inference is likely to be misleading as well.
Therefore, to claim that conclusions are based on FIML inference is to
claim that the empirical model is capable of accounting for all the
systematic information in data in a satisfactory way.
Although the derivation of a FILM estimator subject to
parameter restrictions can be complicated, this is not so when the
parameters of the VAR model (18) are unrestricted. In that case, the
ordinary least squares (OLS) estimators are equivalent to FILM. After
the model has been estimated by OLS, the IN distributional
assumption can be checked against the data using the residuals
εˆt (Hendry and Juselius, 2000).
2.5 Stability and unit-root properties of the model

Up to this point, the VAR model of our study is estimated and
discussed as if its time-series were stationary. But in light of the last
sections discussion we realize that presence of unit-roots in time-
series of the VAR system could cause serious problems regarding
inference of the estimation results and the accuracy of the model’s
predictions. In this section we examine the unit-roots of the time-
series of the VAR model and its characteristics prior to proceeding
28 / Vol. 4, No. 12 / Spring 2007

with estimation of the different versions of the model.

The dynamic stability of the process (4) which is repeated below
for convenience;
k
( 4) X t = ΦDt + ∑ Π i X t −i + ε t ............ε t ~ IN p [0, Ωε ]
i =1
can be investigated by calculating the root of (5):

(8) (Ι p − Π1 L − Π 2 L2 ,......,−Π k Lk ) Χ t = Π ( L) X t
Where Li Χ t = Χ t −i . For a VAR (2) model of our case the

characteristic polynomial could be defined as:
(9) Π ( Ζ) = (Ι p − Π1 z − Π 2 z 2 ).
The roots of Π ( z ) = 0 contain all necessary information about

the stability f the process and therefore, whether it is stationary or
non-stationary. In econometrics, it is usual to discuss stability in terms
of the companion matrix of the system (Hendry, and Juselius, 2000),
which is obtained by staking the variables of the model as a first order
dynamic system:
 X t   Π1 ,...., Π 2  X t −1   ε t 
(10)   =  
  +  ,
 X t −1   I p , .......,0  X t −2   0 
Where the first block is the original system and the second block
is merely an identity for X t −1 . Stability of the system depends on the
Eigen-values of the coefficient matrix in (10), and these are precisely
the roots of Π ( z −1 ) = 0 (Hendry and Juselius, 2000, Banerjee et al.
1993). For a p-dimensional VAR with 2 lags, there are 2p eigen-
values. The following results apply:
(a) if all eigenvalues of the companion matrix are inside the
unit circle, then {Xt }is stationary;
(b) if all the eigenvalues are inside or on the unit circle, then
{Xt }is non-stationary;
Vol. 4, No. 12 / Spring 2007 / 29

(c) if any of the eigenvalues are outsise the unit circle, then {Xt }is
explosive.
For the multivariate (four variable) demand for oil VAR(2) model,
we will have 4×2=8 roots, the model of which are reported directly
from the computer output in table (2) below (rounded to point three
digits):
Table 2. Roots.of .Charagteristic.Polynomial

________________________________________________________________________
Endogenous. var iables : LDOECD( D ),.LIPIOECD(Y ),.LRWTR( P),..LTSOECD( S )
Exogenous. var iables : C
Lag.specificat ion : 12
_________________________________________________________________________
Root.........0.999,..0.945,..0.855,..0.482,..0.326,... − 0.216 − 0.229i,... − 0.021 + 0.229,...0.024
Modulus...0.999,..0.945,..0.855,..0.482,..0.326,......0.230,.....................0.230,...............0.024
_________________________________________________________________________
No.root.lies.outside.the.unit.circle.
VAR.satisfies.the.stability.condition
Figure (10) illustrate these Eigen-values in relations to the unit

circle. We note that the system is stable and no explosive roots are
found in the system of time series, however, there are two near-unit
roots, suggesting the presence of stochastic trends as well a couple of
complex roots. The distinction between a unit-root process and a near
unit-root process need not be crucial for practical modeling. Even
though a system is stable but a couple of rots close to unity (say
ρ ≥ 0.95) as in our case, it is often a good idea to act as if there are
unit roots to obtain robust statistical inference. Now, in our empirical
exercise since there are two roots close to unity for the four variables,
the series seem non-stationary and possibly co-integrated.
Now that our VAR system is shown to be stable, albeit
containing near unit roots characteristics, we could address the non-
stationarity issue in the time-series of the model to obtain a set of
robust and consistent results from our estimation exercises.
Theoretically, the unit-root assumption implies an ever-increasing
30 / Vol. 4, No. 12 / Spring 2007

variance to the time series (around a fixed mean), violating the

constant-variance assumption of a stationary process. Of course the
stability of the system was detectable given the estimation results of
the unrestricted VAR model in the level of time-series and dynamic
responses of the variables to the shocks, in the previous section of the
paper.
Fig. 11. The

Fig.eigenvalues of the companion
10 The eigenvalues matrix Inverse
of the companion Roots of AR
matrix
Characteristic Polynomial
Inverse Roots of AR Characteristic Polynomial
1.5
1.0
0.5
0.0
-0.5
-1.0
-1.5
-1.5 -1.0 -0.5 0.0 0.5 1.0 1.5
In this part of the paper we will estimate the model after having
examined the hypothesis of the variables of the system being I(1).
Given the time series of the model are I(1) we first will discuss its
short-run features by transferring data to a set of stationary time-
series. In the next part of the paper we will embark on a VEC
modeling of the time-series examining the co-integration relations and
the long-run characteristics of the system. On the basis of the
preceding discussion our analysis would proceed with a formal test of
the integration of the VAR model time-series. Two forms of the
Vol. 4, No. 12 / Spring 2007 / 31
augmented Dickey-Fuller (ADF) tests were estimated where each

form differs in the assumed deterministic component(s) in the series
i.e:
P
(11) ∆X t = β1 + β 2 X t −1 + ∑ β 3 ∆ X t −1 + ε t ;.................cons tan t.only
i =1
P
(12) ∆X t = β1 + β 2 t + β 3 X t −1 + ∑ β 4 ∆X t −1 + ε t ....;..cons tan t.and .trend ..
i =1
As usual ε t is assumed to be a Gaussian white noise random

error and t=1,..,T (number of observations in the sample) is a time
trend term.
Although the tests were conducted for both forms of the ADF
tests mentioned above, but in fact we needed to examine only the first
test, i.e. the expression (11), because according to the descriptive
statistics reported on table (1) the hypothesis “ E[∆X i ] = 0 ” could not
be rejected for non of the variables of the model. However, estimating
P
the second expression i.e ∆X t = β 1 + β 2 t + β 3 X t −1 + ∑ β 4 ∆X t −1 + ε t . for
i =1
all four variables of the model yielded the following results:
Table 3. Estimation.results. for.time − trend .coefficients.of .the.

var iables.in.equ..(12)
___________________________________________________________
Variables.................................LD...............LP..............LS ..............LY
Time.ternd .Coefficient.........0.0004.........0.0004......0.00001.....0.00004
t − Statistics.........................(5.02)...........( 2.11).........(0.61)...........(1.3).
____________________________________________________________
As we can see coefficients of LD and LP are very small indeed and
coefficients of the two other variables are small and statistically
insignificant. Therefore, since we had found E[∆X i ] = 0 , [the
hypothesis that the mean of the first difference of the variables is not
significantly different from zero cannot bee rejected], which is now
supported with these statistical evidence, applying the ADF test with
32 / Vol. 4, No. 12 / Spring 2007

constant term only is what would be needed for a statistical unit-root

test of the time-series of our VAR model.
Table (4) contains the results from the ADF test. The number of
lagged differences, p, is chosen to ensure that the estimated errors are
not serially correlated based on the Akaike information Criterion
(AIC). The Akaike Information Criterion (AIC) is computed as:
(13) AIC = −2l / T + 2n / T
where.n.is.number.of . parameters.estimate.and .l.is.thelikelihood .defined .as. follows :
l = −T
2[1 + log(2π ) + log(εˆ ' εˆ / T )]
ˆ
ε .is.the.residual.and .T .is.number.of .the.sample.observations
The AIC is often used in model selection for non-nested
alternative-smaller values of the AIC are preferred. For example one
can choose the length of a lag distribution by choosing the
specification with lowest value of the AIC. The Schwarz Criterion
(SC) is an alternative to the AIC that impose a large penalty for
additional coefficients [see also eq. (16) below].
Table (4) and (5) contains the results from the ADF tests for the
variables in level and in first difference respectively. Between them
these two tables test the hypothesis whether the time-series of the
model are I(1). The first column of the tables refer to the number of
lags, p,, in each regression. This is followed by set of three figure for
each lag under each variable.
The first figure is the t-statistic for the ADF test that is associated
with the last lagged difference variable in each equation, followed by
the MacKinnon one sided p value and the AIC. The null hypothesis in
each set is that there is a unit-root in the equation of concern or
equivalently the series is I(1). This implies of the coefficient being
zero. It is well known that because of the properties of non-stationary
process, the distributions of the statistics are different. The critical
values are given at the bottom of the tables. AIC criterion is used in
evaluating the appropriate number of lags in the testing procedure that
remove serial correlation in the residuals with smaller values of
information criteria being preferred.
Vol. 4, No. 12 / Spring 2007 / 33

Table.4.. ADF .tests. for.Unit − Root..(Variables.in.level )

_____________________________________________________________________________
.........................LD...................................LP.............................LS ................................LY
Lags....t − ADF / Pr ob× / AIC...t − ADF / Pr ob. / AIC...t − ADF / Pr ob / AIC...t − ADF / Pr ob / AIC
_____________________________________________________________________________
(14)..... − 1.73 / 0.73 / − 5.25..... − 2.90 / 0.16 / − 2.26..... − 3.80∗ / 0.02 / − 5.75..... − 0.94 / 0.77 / − 7.81
(13)..... − 2.46 / 0.13 / − 5.15..... − 2.63 / 0.26 / − 2.25..... − 3.50∗ / 0.04 / − 5.77..... − 0.88 / 0.79 / − 7.81
(12)..... − 2.63 / 0.09 / − 5.17.... − 3.21∗ / 0.08 / − 2.25..... − 3.61∗ / 0.03 / − 5.77..... − 0.51 / 0.88 / − 7.81
(11)... − 3.13∗ / 0.03 / − 5.18.... − 3.20∗ / 0.08 / − 2.27..... − 2.42 / 0.36 / − 5.56..... − 0.75 / 0.83 / − 7.82
(10)..... − 2.25 / 0.19 / − 4.65..... − 2.74 / 0.22 / − 2.26...... − 2.48 / 0.34 / − 5.59...... − 1.02 / 0.74 / − 7.80
(09)..... − 2.46 / 0.14 / − 4.52...... − 2.14 / 0.51 / − 2.22..... − 2.10 / 0.53 / − 5.58...... − 0.92 / 0.78 / − 7.80
(08)..... − 2.32. / 0.16 / − 4.47.... − 2.24 / 0.46 / − 2.24...... − 2.01 / 0.58 / − 5.60....... − 0.83 / 0.81 / − 7.82
(07)..... − 2.49 / 0.12 / − 4.47..... − 2.17 / 0.50 / − 2.26...... − 2.00 / 0.59 / − 5.62...... − 1.15 / 0.70 / − 7.82
(06)... − 3.35∗ / 0.01 / − 4.33...... − 2.19 / 0.49 / − 2.28..... − 2.85 / 0.18 / − 5.14...... − 0.96 / 0.76 / − 7.83
(05)... − 3.14∗ / 0.03 / − 4.33..... − 2.17 / 0.50 / − 2.29...... − 2.01 / 0.20 / − 5.58...... − 0.82 / 0.81 / − 7.84
(04).. − 3.66∗∗ / 0.01 / − 4.32..... − 2.05 / 0.50 / − 2.32...... − 3.34 / 0.05 / − 5.56..... − 0.56 / 0.83 / − 7.84
(03)... − 3.50∗ / 0.07 / − 4.32..... − 2.05 / 0.50 / − 2.32..... − 3.81∗ / 0.02 / − 5.59..... − 0.67 / 0.85 / − 782
(02).. − 2.92∗∗ / 0.04 / − 4.28..... − 1.99 / 0.59 / − 2.33...... − 3.22 / 0.08 / − 5.54..... − 0.61 / 0.86 / − 7.81
(01).. − 3.81∗∗ / 0.00 / − 4.25..... − 2.11 / 0.53 / − 2.35...... − 2.94 / 0.15 / − 5.53...... − 0.60 / 0.86 / − 780
(00).. − 5.16∗∗ / 0.00 / − 4.23..... − 1.87 / 0.86 / − 2.35...... − 2.75 / 0.21 / − 5.51..... − 0.57 / 0.87 / − 7.81
______________________________________________________________________________
Test critical values : 1% level = 3.481623,...5% level = 2.883930,...10% level = 2.578788
×
MacKinnon (1996) one - sided p - values.
∗
Significant at 5%
∗∗
Significant at 1%
34 / Vol. 4, No. 12 / Spring 2007

Table.5.. ADF .tests. for.Unit − Root..(Variables..in. first .difference×× )

______________________________________________________________________________________
.......... .......... .∆LD.................... .......... .∆LP.......... .......... ........∆.LS .......... ..............∆LY
Lags....t − ADF / Pr ob× / AIC...t − ADF / Pr ob. / AIC...t − ADF / Pr ob / AIC...t − ADF / Pr ob / AIC
______________________________________________________________________________________
(14).. − 3.59∗∗ / 0.07 / − 5.21... − 3.38∗ / 0.01 / − 2.25... − 2.93∗ / 0.04 / − 5.65... − 3.05∗ / 0.03 / − 7.80
(13).. − 3.90∗∗ / 0.00 / − 5.24... − 2.75∗ / 0.06 / − 2.21... − 3.04∗ / 0.03 / − 5.66... − 3.55∗∗ / 0.01 / − 7.82
(12).. − 6.18∗∗ / 0.00 / − 5.12... − 2.90∗ / 0.04 / − 2.22... − 3.03∗ / 0.03 / − 5.68... − 3.92∗∗ / 0.00 / − 7.84
(11).. − 7.86∗∗ / 0.00 / − 5.13... − 2.37 / 0.15 / − 2.19...... − 2.79 / 0.06 / − 5.60...... − 3.68∗∗ / 0.00 / − 7.83
(10).. − 15.3∗∗ / 0.00 / − 5.12... − 2.39 / 0.14 / − 2.21....... − 3.87∗∗ / 0.00 / − 5.58... − 3.84∗ / 0.01 / − 7.81
(09).. − 9.70∗∗ / 0.00 / − 4.62... − 2.74∗ / 0.07 / − 2.23... − 3.92∗∗ / 0.00 / − 5.57... − 3.37∗ / 0.03 / − 7.80
(08).. − 8.36∗∗ / 0.00 / − 4.49... − 3.59∗∗ / 0.01 / − 2.21... − 4.95∗∗ / 0.00 / − 5.58... − 3.04∗ / 0.03 / − 7.80
(07).. − 8.02∗∗ / 0.00 / − 4.45... − 3.67∗∗ / 0.50 / − 2.26... − 5.94∗∗ / 0.00 / − 5..59... − 3.17∗ / 0.02 / − 7.83
(06).. − 8.72∗∗ / 0.00 / − 4.44... − 4.03∗∗ / 0.00 / − 2.25... − 6.97∗∗ / 0.00 / − 5.61... − 3.09∗ / 0.03 / − 7.82
(05).. − 6.52∗∗ / 0.00 / − 4.26... − 4.18∗∗ / 0.00 / − 2.27... − 5.75∗∗ / 0.00 / − 5.52... − 3.07∗ / 0.03 / − 7.84
(04).. − 3756∗∗ / 0.00 / − 4.28... − 4.67∗∗ / 0.00 / − 2.28... − 6.49∗∗ / 0.00 / − 5.54... − 3.55∗∗ / 0.00 / − 7.85
(03).. − 7.40∗∗ / 0.00 / − 4.28... − 5.99∗∗ / 0.00 / − 2.29... − 5.90∗∗ / 0.00 / − 5.51... − 3.73∗∗ / 0.00 / − 785
(02).. − 7.76∗∗ / 0.00 / − 4.24... − 6.94∗∗ / 0.00 / − 2.31... − 5.62∗∗ / 0.00 / − 5.50... − 4.94∗∗ / 0.00 / − 7.83
(01).. − 12.7∗∗ / 0.00 / − 4.23... − 8.36∗∗ / 0.00 / − 2.33... − 7.69∗∗ / 0.00 / − 5.50... − 6.77∗∗ / 0.00 / − 7.82
(00).. − 16.1∗∗ / 0.00 / − 4.16... − 10.5∗∗ / 0.00 / − 2.34... − 11.1∗∗ / 0.00 / − 5.50... − 11.7∗∗ / 0.00 / − 7.80
______________________________________________________________________________________
Test critical values : 1% level = 3.481623,...5% level = 2.883930,...10% level = 2.578788
×
MacKinnon (1996) one - sided p - values.
××
First - difference tests have a constant included
∗
Significant at 5%
∗∗
Significant at 1%
All four variables of the model, i.e. LD, demand for oil; LP,
WTI oil bench mark price; LS, stock of crude and products and LY,
an index of industrial production in OECD appear to be I(1) processes.
The LY series is clearly an I(1) process, failing to reject the null
hypothesis of a unit-root at each of the 14 lags. The t-ADF tests for
the first three of the four variables seem to be significant for some
legs. This could lead to a rejection of the null hypothesis of a unit root
particularly in case of LD, nevertheless, further testing revealed that
theses series were non-stationary particularly because of presence of
large outliers. As Hendry and Juselius (2000) argue, “most economic
time series are non-stationary, and at best become stationary after
differencing. Therefore, stationarity is considered for a differenced
Vol. 4, No. 12 / Spring 2007 / 35
series {∆X t } or for the IID.errors.{ε t } . The distinction between a unit-

root process and a near unit-root process need not be crucial for
practical modeling. Even though a variable is stationary, but with a
root close to unity (say, ρ > 0.95) , it is often a good idea to act as if
there are unit roots to obtain robust statistical inference”.
3. Specification of the VAR Model

Now that we have established the fact that the time series composing
our VAR model are I(1) processes and there are clear signs of co-
integration or long-run relationship between them, we are in a
opposition to proceed with specification and estimation the VAR
model prior to testing for co-integration and then estimation the VEC
model to use it for forecasting the market developments.
A general to specific approach is adopted here as Hendry (1986)
and Hendry and Juselius (2000, 2001). First we will determine the lag
structure of the VAR model. The VAR model (2) is general enough to
accommodate any number of lag structures, so this must be
determined prior to conducting the analysis. Then using the results of
estimation the unrestricted VAR model in the preceding section, the
VAR model will be re-estimated. Once a correctly specified model
emerges from this process, restrictions are imposed on the model to
give an economic interpretation for a statistically sound and robust
model.
The test for a long-run relationship between demand for oil,
industrial production, stocks of crude and products and crude oil
prices starts with the estimation of the four variables VAR model. The
VAR model can be specified in matrix form as:
 LDt ( Demand . for .Oil )   LDt − i  ε 1t 
 LP (Oil . Pr ice.WTI )     
(14)  t  = Φ cons tan t  + Π ( Li )  LPt − i  + ε 2 t 
 LS t ( Stock .of .Crude & Pr oducts )    i
 LS t − i  ε 3t 
timrtrend t 
     
 LYt ( Industrial . Pr oduction )   LYt − i  ε 4t 
The time series have been transformed to logarithms to address
heterokedasticity issues. Constant (and trend) terms are included in
each equation; their role will be modified at a later stage on the basis
36 / Vol. 4, No. 12 / Spring 2007

of statistical examination of the series behaviors. The error terms are

assumed to be white noise and can be contemporaneously correlated.
The expression Π (L ) is a lag polynomial operator indicating that p
lags of each series is used in the VAR. The individual Π i terms
represent a 4 × 4 matrix of coefficients at the ith lag and the Φ matrix
is a 4 × 2 matrix. The other variables, LD, LP, LS,LY, constant, time
trend and error terms are scalar.
The number of lags to the variables is unknown at the
beginning. The selection methodology starts with an initial maximum
number of p lags which are assumed to be in excess to the minimum
required lags. Residual diagnostics tests like normality, serial
correlation and heterokedasticity are conducted and the VAR model is
tested for stability. The main objective of these tests is to make sure
that the results are close enough to the assumption of white noise
residuals. A large number of lags are most likely to produce over-
parameterized model. Nevertheless, a convincing econometric
analysis needs to start with a statistical model of the data generation
process and then conduct the relevant tests to achieve parsimony with
fewest number of lags capable of explaining the dynamics of the
system.
3-1. Lag length selection

The selection criteria for the appropriate lag length of the unrestricted
VAR models employ χ 2 tests and F-tests. Table (5) shows results of
tests of lag length on the basis of χ 2 tests. The selection procedure
involves choosing the VAR (p) model with the highest value of AIC,
SBC or the HQ and lowest value of FPE. In practice, the use of SBC
is likely to result in selecting a lower order VAR model than when
using the AIC. However, in using both criteria it is important that the
maximum order chosen for the VAR is high enough for high-order
VAR specification. As it can be seen we have chosen Max. order of
eight lags which is supposed to be sufficient. All the nine VAR (p),
0=0, 1,…, 8, are estimated over the same sample period. As to be
expected the maximized values of log-likelihood function given under
Vol. 4, No. 12 / Spring 2007 / 37

the column LogL increase with p. The Hannan-Quinn (HQ) and the
Schwartz (SC) criterions select the order 1 while the Akaike (AIC)
and the Final Prediction Error (FPE) select the order 2. However, the
log-likelihood ratio statistics rejects order 1, but do not reject a VAR
of order 2.
The log-likelihood ratio statistics (LR column on table 5) are
computed for testing the hypothesis that the order of the VAR is (p)
against the alternative that it is P (the Maximum expected order), for
p=1,2… ,P-1. To test this hypothesis one should construct the relevant
log-likelihood statistics for these tests by using the maximized values
of the log-likelihood function given in the relevant column of the
result table. For example, to test the hypothesis that the order of the
VAR model is 2 against 3 the relevant log-likelihood ration statistics
is given by:
(15) LR (2 : 3) = 2( LogL3 − LogL2 )
Where LogLp =p=1,2,..,p refers to the maximized value of the
log-likelihood function for the VAR(p) model. Under the null
hypothesis, LR (2:3) is distributed asymptotically as a chi-squared
variate with m 2 (3 − 2) = m 2 degrees of freedom, where m is the
dimension of coefficient vector of the variables in an standard VAR(p)
model.
Table 5. Testsoflaglengthor Model Reduction for VAR
Lag LogL ..............LR ..............FPE ..............AIC ................SC ....................HQ
____________________________________________________________________________
0 736.1135 ....NA ............. 2.48e - 10 -10.76638 -10.68071 -10.73156
1 1450.608 1376.453 8.58e - 15 -21.03836 - 20.61003 * - 20.86430 *
2 1466.798 30.23674 8.56e - 15 * - 21.04115 * -20.27015 -20.72784
3 1478.728 21.57805 9.10e - 15 -20.98129 -19.86762 -20.52872
4 1495.090 28.63356 9.08e - 15 -20.98661 -19.53028 -20.39480
5 1513.493 31.12377 8.80e - 15 -21.02196 -19.22297 -20.29089
6 1526.956 21.97606 9.20e - 15 -20.98465 -18.84299 -20.11433
7 1546.722 31.10212 * 8.79e - 15 -21.04003 -18.55570 -20.03046
8 1556.867 15.36716 9.71e - 15 -20.95393 -18.12694 -19.80511
_____________________________________________________________________________
* indicates lag order selected by the criterion
LR : sequential modified LR test statistic (each test at 5% level)
FPE : Final prediction error
AIC : Akaike information criterion
SC : Schwarz information criterion
HQ : Hannan - Quinn information criterion
38 / Vol. 4, No. 12 / Spring 2007

To decide on the most desirable order of the VAR model we

note that the BSC, HQ and AIC statistics are all closely related. In
each case, the log determinant of the estimated residual covariance
matrix is computed and added to term that exacts as a penalty for the
increased number of parameters used in the estimation. The BSC, HQ
and AIC differ in the magnitude of the penalty term. Each used as
alternative criterion in testing, because each reflects the tradeoff
between increasing the precision of the estimates and the possible
over-parameterization associated with the loss of parsimony and
degree of freedom. The expression for the three criterions could be
given as follows (Villar, and Joutz, 2006):
(16) ( )
AIC = log DetΣˆ + 2 × c × T −1
( )
BSC = log DetΣˆ + 2 × c × log(T )× T −1
( )
HQ = log DetΣˆ + 2 × c × log(log(T )) × T −1
The first terms on the right-hand side of the equations are the
log determinants of the estimated residual covariance matrix. The log
determinant of the estimated residual covariance matrix will decline as
the number of regressors, just as in a single equation ordinary least
squares regression. It is similar to the residual sum of squares or
estimated variance. The second term on the right-hand side acts as a
penalty for including additional regressors (c) which scaled by the
inverse of the number of observations (T). The lag length chosen is
the model with minimum value for the Statistics. The three tests do
not always agree on the same number of lags. In practice, the use of
the SBC is likely to result in selecting a lower order VAR model than
when using AIC. Notice that it is quite usual for the SBC to select a
lower order VAR as compared with the AIC. Also as was discussed in
our case and according to the statistics given on table (5) order 1 is
rejected by the log-likelihood ratio. In the light of these reasons we
choose the VAR (2) model.
Vol. 4, No. 12 / Spring 2007 / 39

3.2 Estimation results of the VAR (2) model

Having decided on the order of the VAR model we could now proceed
with estimation of our VAR (2) model. In section (4.3) “a tentative
VAR(2) model” we in fact estimated the VAR(2) model in level of
time-series. However, now that we have found the time series of our
system are I(1) and since on the other hand in this part of the study we
are mainly concern with the short-run developments of the oil markets
in OECD, therefore we will estimate the first differenced form of the
VAR (2) model as follows:
(17) ∆X t = ΦD 't + Π1∆X t −1 + Π 2 ∆X t − 2 + ε ......
Which in extended form of or fourvariate VAR (2) model

becomes:
 ∆Dt   ∆Dt −1   ∆Dt − 2  ε 1 

 ∆P   ∆P     
(18 )  t  = Φ D ' + Π  t −1  + Π  ∆Pt − 2  + ε 2 
1 2
 ∆S t  t
 ∆S t −1   ∆S t − 2  ε 3 
       
 ∆Yt   ∆Yt −1   ∆Yt − 2  ε 4 
The estimation results are given below. As can be seen from

these results in the time period of concern, income elasticity of
demand for oil in OECD has been around 1 and statistically
significant, indicating a 1% increase in industrial production, in
previous time period, would cause an increase in demand for oil with
a magnitude of slightly less than 1% (0.96%). Also it is interesting to
see that changes in stocks of crude and products has significant
impacts on the both rates of oil demand and particularly oil price with
expected signs. We also notice that oil prices changes have no
significant impact on demand for oil in the short-run but, perhaps
surprisingly, exert some negligible impact on industrial production
rate.
40 / Vol. 4, No. 12 / Spring 2007

Estimation. Re sults.of .the.Short − run.VAR.(2).Model : ∆X t = ΦD't +Π 1∆X t −1 + Π 2 ∆X t −2 + ε t

____________________________________________________________________________
∆Dt  − 0.002 − 0.10,.... − 0.03......0.87 .....0.96 
∗ ∗
∆Dt −1 
∆P  0.004    ∆P 
 + − 0.19........0.11... − 1.79 .....1.11 
∗
(19)  t =  t −1 
∆S t  0.001  − 0.17 ∗......0.03... − 0.14.... − 041.  ∆S t −1 
   ∗ 
   
∆Yt  0.002  − 0.01........0.02 ∗ − 0.01.... − 0.02.  ∆Yt −1 
− 0.14..... − 0.02.... − 0.03.......0.66  ∆Dt − 2  ε 1t 
− 0.23..... − 0.06.......0.38.... − 0.24     
  ∆Pt − 2  + ε 2 t 
0.04........ − 0.00.......0.32 ∗.. − 0.11  ∆S t − 2  ε 3t 
    
0.00......... − 0.00......0.03.... − 0.18  ∆Yt − 2  ε 41 
∗
∗
.Significant.at.5%.level
1  0.00073
0.06.......1.0  0.00515
Ω = . ................σˆ ε =  
0.72.......0.10......1.0  0.00022
   
0.021.....0.10......0.11.....1. 0.00002
Statistical. for.individual. var iables........D............P...........S ...........Y

R 2 .........................................................0.29........0.13......0.10......0.11
Adj.R − Squared ...................................0.24........0.08.......0.03......0.05
F − Statistic..........................................6.77........2.52......1.70......2.00
Common.Sample., Akaik .inf ormation.Criterion( AIC ),.and .Schwartz.Criterion
ˆ = −14.10,..AIC = −20.80,..SC = −20.10
Log ( L max) = 1501,....log Ω
D(LD) Residuals D(LP) Residuals
.08 .2
.04 .1
.00 .0
-.04 -.1
-.08 -.2
1996 1998 2000 2002 2004 2006 1996 1998 2000 2002 2004 2006
D(LS) Residuals D(LY) Residuals

.04 .015
.010
.02
.005
.00
.000
-.02
-.005
-.04
-.010
-.06 -.015
1996 1998 2000 2002 2004 2006 1996 1998 2000 2002 2004 2006
Vol. 4, No. 12 / Spring 2007 / 41

Inspecting the graphs of residuals series of the variables of the

estimated VAR model together with the residuals’ empirical
distribution (below) clearly shows that standard assumption of OLS
estimation regarding stationarity of the residuals and normality of
their distribution are satisfied supporting statistically robustness of the
estimation results.
It is worth noting that the volatility of oil markets reflected
particularly on rate of changes of oil prices and inventory levels, and
also existence of outliers in the time series inevitably contribute to low
explanatory power of the estimated model. This should be mentioned
that we have not used dummy variables in the estimated models.
Dummy variables could capture effects of particular events enhancing
models goodness of fit especially when there are many outliers in the
time series of the model.
Fig. 12. ImpliedFig.

Empirical Density of VAR (2) in First Differenced
Implied Empirical Density of VAR(2) in First Differenced
D(LD) D(LP)
25 8
Below we have presented graphs6 illustrating response of our

20
VAR15(2) model’s variables to different shocks. As was discussed very

Density
Density
briefly at the beginning of the paper, 4 a Vector Auto-Regression

10
(VAR) system and closely related Vector Error Correction model
2
possess
5
a very rich set of dynamics which uncovered through the use
of impulse
0 response functions. It is 0well known that any single
-.08 -.04 .00 .04 .08 .12 -.3 -.2 -.1 .0 .1 .2 .3
variable auto-regression has a moving average representation.
Therefore, a natural D(LS)
generalization of this is that D(LY)
any VAR (or
50 120
respected VEC) models have a vector moving average (VMA)
100
representation.
40
For example it can be shown that one can arrive to the
80
following
30 VMA by necessary manipulation of our four variables VAR
Density
Density
60
model:
20
40
10
20
0 0
-.08 -.04 .00 .04 .08 -.02 -.01 .00 .01 .02
42 / Vol. 4, No. 12 / Spring 2007

 Dt  α1  φ11 (i )......φ12 (i )......φ13 (i ).....φ14 (i )  ε1, t − i 

 P  α  ∞ φ (i ).....φ (i )......φ (i ).....φ (i ) ε 
 t  =  2  +  21   2,t − i 
 St  α 3  ∑
22 23 24
(20)  
i = 0 φ31 (i ).....φ32 (i )......φ33 (i ).....φ34 (i )  ε 3, t − i

      
Yt  α 4  φ41 (i ).....φ42 (i )......φ43 (i ).....φ44 (i ) ε 4,t − i 
There is an analogous VMA for the VEC model. The sixteen
sets of coefficients φ ij (i ) are the impulse response functions. These
give us the effect of the shocks ε 1t ,.ε 2t , ε 3t and ε 4t on the entire time
paths of the entire sequences of {Dt}, {Pt}, {St} and.{Yt}. Notice that
for i=0, the coefficients give the impact response. After n periods, the
cumulative sum of the effects of, say ε 2t , which can be thought of as
impact of a shock to Pt, on Dt is given by:
n
( 21).......∑ φ12 (i )
i =0
Of interest in this study is the elasticity of response of one
variable to another. This can be calculated as the dynamic correlation.
Suppose that we are interested in the dynamic path of the elasticity of
response of demand to a shock in Yt . This is given by the dynamic
correlation:
n
∑φ 14 (i )
( 22) ρ (i ) = i =0
n
∑φ
i =0
44 (i )
This would give us the time path of the elasticity. It should be

noted that analysis using the impulse response function is completely
analogous to forecasting. In an impulse response function framework,
if we shock one variable, say P, and trace the response of another
variable say D, in fact we are forecasting the future path of D, given
some future values of P.
Some interesting observations could be detected inspecting
dynamics of the responses of the rate of changes of the variables of
the model to innovations. For example, while impact of a shock to the
rate of changes of demand for oil on the rate of changes of oil priced
is as expected opposite to the impact of an impulse to the rate of
Vol. 4, No. 12 / Spring 2007 / 43
changes of oil prices on demand for oil but the magnitudes of impacts
are different as a shock to the rate of changes of demand for oil has
greater effect on the rate of oil price changes vice versa. Also we
notice that almost all the shocks are faded in 5 to 7 time periods. So,
although a shock to the rate of changes of stocks (crude and products)
on oil price is almost twice as its impact on demand for oil (in
absolute terms), however, both impulse impacts fade away in
approximately the same time period.
Fig. 13. Dynamics Fig.
of the Short-run
Dynamics of the Model
Short-run(39) Response
Model (39) to Cholesky
Response
Oneto Cholesky One S.D. Innovations
S.D. Innovations ± 2 S.E. ± 2 S.E.
Response of D(LD) to D(LP) Response of D(LD) to D(LY)
.04 .04
.03 .03
.02 .02
.01 .01
.00 .00
-.01 -.01
-.02 -.02
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Response of D(LP) to D(LD) Response of D(LP) to D(LS)

.12 .12
.08 .08
.04 .04
.00 .00
-.04 -.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Response of D(LY) to D(LD) Response of D(LS) to D(LP)

.006 .015
.010
.004
.005
.002 .000
-.005
.000
-.010
-.002 -.015
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
44 / Vol. 4, No. 12 / Spring 2007

3.3 Different EC representation of the unrestricted VAR

The unrestricted VAR model that we estimated and discussed its
various characteristics in the preceding sections of this paper, can be
given different parameterization without imposing any binding
restrictions on the model parameters, i.e. without changing the value
of the likelihood function (Juselius, 2003). The formulation of the
VAR model in the so called vector error correction (VEC) or
equivalently, vector equilibrium correction (VEq.C) model (Hendry,
2000) gives a convenient formulation of the model (20) i.e.
( 6) X t = ΦDt + Π1 X t −1 + Π 2 X t − 2 + ε t
t = 1,...., T , and ..ε t ~ N p (0, Ω)
in terms of differences, lagged differences, and levels of the

process. The analysis could benefit from these representations in
several ways:
(i) The multicollinearity effect which typically is strongly
present in time series data is significantly reduced in error-
correction form. Differences are much more ‘orthogonal’
than the levels of variables.
(ii) All information about effects are summarized in the levels
matrix Π which can, therefore, be given special attention
when solving the problem of co-integration.
(iii) The interpretation of the estimates is more intuitive, as the
coefficients can be naturally classified into short-run effect
and long-run effects.
(iv) The VEC formulation directly addresses the reasons
behind the changes to the variables of the system.
Here we discuss three different versions of the VAR(k), following

the same procedure adopted in Hendry and Juselius(2000) and
Juselius(2003). As we found the optimal lag length of our VAR model
2 so the lag length of all representation models also are confined to
Vol. 4, No. 12 / Spring 2007 / 45
k=2. It would enable us to explain the main points of our argument

without loss of generality. The purpose is to illustrate how the
estimates could look different although the model is exactly the same.
As discussed earlier, so long as the parameters (Φ, Π 1 , Π 2 , Ω ) in
(6) formulation are unrestricted, OLS can be used to estimate them.
Therefore, any of the three formulation of the VAR model that will be
discussed below, can be used to obtain the unrestricted estimates of
the VAR model. The important point is that although the parameters
differ in the four representations, each of them explains exactly as
much of variation in Xt.
The first reformulation of model (6) is into the following error
(equilibrium) correction form:
(23) ∆X t = ΦDt + Γ1(1) ∆X t −1 + Π X t −1 + ε t

where.Π = Ι − Π1 − Π 2 ,.and .Γ1(1) = −Π 2, ,..ε t ~ IN p [0, Ωt ]
In (23) the lagged levels matrix Π has been placed at time t-1,
but could be chosen at any feasible lag without changing the
likelihood.
The estimated coefficients reported below. As it can be seen
most of the significant coefficients are now located in the lagged level
matrix Π whereas only 3 out of 16 coefficients in the Γ1(1) matrix
seem significant. Among the Π matrix coefficients three are placed
on the diagonal indicating (autoregressive) significant effects of the
changes in last period (last months) levels of demand for oil, oil price
and the commercial crude and product stocks on the rate of the
changes of these variables in the present period (month). The
remaining three illustrate significant impacts of the changes in
(lagged) level of production on oil demand and oil price and that of oil
price on production.
46 / Vol. 4, No. 12 / Spring 2007

The.Estimated .Model..∆X t = ΦD + Γ1(1) ∆X t −1 + ΠX t −1 + ε t

________________________________________________________________________
 ∆Dt  2.12  0.02.. − 0.026......0.39∗......0.67  ∆Dt −1 
 ∆P  6.8    
 + 0.23......0.10.... − 1.65 ......1.00  ∆Pt −1  +
∗
(24)  t =
 ∆S t  2.67∗   − 0.02...0.013.. − 0.05..... − 0.45 ∆St −1 
      
 ∆Yt  − 0.24   − 0.003..0.02 ... − 0.02....0.04  ∆Yt −1 
∗
− 0.42∗... − 0.002....0.11........ 0.15∗   Dt −1  ε1, t 

    
 − 0.48..... − 0.05∗.... − 0.25.....0.43∗   Pt −1  ε 2 ,t 
. +
− 0.11..... − 0.001... − 0.12∗....0.06   St −1  ε 3,t 
    
− 0.004......0.003......0.02...... − 0.02 Yt −1  ε 4 ,t 
1.0  0.00066
0.05......1.0   
Ω= ,..σˆ ε = 0.00502
0.75......0.10.......1.0  0.00022
   
 0 .03 ........ 0 .13...... 0 .087...... 1 .0  0.00002
Statistics.. for.individual.. var iables.......D.......... .......P.......... .....S .......... ...Y

R 2 .......... .......... .......... .......... .......... .......0.36.......... ..0.15.......... 0.10.......0.10
Adj − R 2 .......... .......... .......... .......... .......0.32.......... ..0.10.......... 0.05........ 0.05
F − statisic.......... .......... .......... .......... ....9.26.......... .2.9.......... ..1.9.......... .1.97
Common.sample.statistics ,. Akaik .Information.Criterion ( AIC ), and .Schwartz.Criterion ( SC )

ˆ = −32.86,.. AIC = −21, ,.SC = −20
Log ( L max) = 1534.9,..... log Ω
________________________________________________________________________
Altogether, estimating the model exclusively in difference, i.e.

setting ΠX t −1 = 0 would not provide many interesting results. But, on
the other hand including this ΠX t −1 in the model raises the question
of non-stationarity problem. Since a stationary process cannot be
equal to a non-stationary process, the estimation results can only make
sense if ΠX t −1 defines stationary linear combinations of the variables.
For example the first and third row of ΠX t −1 can be respectively
reformulated as:
Vol. 4, No. 12 / Spring 2007 / 47

(25) First.row... − 0.42( Dt −1 + 0.005 Pt −1 − 0.26 St −1 − 0.36Yt −1 )

Third .row.. − 0.12(.92 Dt −1 + 0.01Pt −1 + St −1 − 0.5Yt −1 )
If the linear combination in the parentheses defined two
stationary variables, then all parts of the first and third equation in the
system would be stationary and, therefore, balanced. This is in fact
what co-integration analysis does: it defines stationary linear
combinations between non-stationary time-series so that an I(1)
process can be reformulated exclusively in stationary variables.
However, it is important to have economically meaningful
interpretation to these linear combinations by imposing relevant
restrictions for identifying the parameters. For example the above
relations might be interpreted as the deviation of observed demand for
oil (in case of the first row) from a steady state oil demand relation,
Dt −1 − Dt*−1 or actual inventory level(in case of the third row)
S t −1 − S t*−1 of the commercial crude and products in OECD from a
steady state level of stocks where:
.(26) Dt* = −0.005Pt −1 + 0.26 St −1 + 0.36Yt −1
St* = −.92 Dt −1 − 0.01Pt −1 + 0.5Yt −1
In order to make these issues clear we should find-out whether
demand for oil (or stock levels) has a unit coefficient or possibly some
coefficients could be set zero.
Note that Log ( Lmax ) and log Ω̂ are exactly the same as for the
unrestricted VAR in the
previous section. This clearly shows that from a likelihood point of
view the models are identical because the residuals are the same in all
VEC representatives and all residual tests of information criteria are
identical, whereas tests of the significance of single variables need not
be and usually are not. For example, the single F-tests of the lagged
variables in differences are very different when compared to the two
successive specifications, whereas the tests values for the lagged
variables in levels are identical. This illustrate that Π matrix is
invariant to linear transformations of the VAR system but not the Γ1m
48 / Vol. 4, No. 12 / Spring 2007

matrices, which depends how we chose m (Juselius, 2003).
Fig. 14. Response to Cholesky One S.D. Innovations ± 2 S.E.

In Model in(22)
Model (22)
.03 .03
.02 .02
.01 .01
.00 .00
-.01 -.01
-.02 -.02
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
.08 .08
.06 .06
.04 .04
.02 .02
.00 .00
-.02 -.02
-.04 -.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Response of D(LS) to D(LY) Response of D(LP) to D(LY)

.015 .08
.010 .06
.005 .04
.000 .02
-.005 .00
-.010 -.02
-.015 -.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Vol. 4, No. 12 / Spring 2007 / 49

We now turn to an alternative formulation of the ECM where we

set m=2. In this case our VAR model in VEC mode becomes:
( 27 ) ∆X t = Φ Dt + Γ1( 2 ) ∆X t −1 + Π X t − 2 + ε t
with .Π = Ι − Π 1 − Π 2 .and .Γ1( 2 ) = (Ι − Π 1 )
Thus, the matrix Π remains unchanged, but Γ1(1) matrix changes

to Γ1( 2 ) . This latter matrix measures the cumulative long-run effect,
whereas Γ1(1) in (23) describe ‘pure’ transitory effects measured by
the lagged changes of the variables. While the explanatory power is
identical for the two model versions, the estimated coefficients and
their p-values can vary considerably. Usually many more significant
coefficients are obtained with formulation (27) compared with (23).
Estimated model of formulation (27) is reported in (28) below. We
notice some interesting changes in this representation compared the
previous one. Impacts of (lagged) changes in stocks level on (rate of
changes of) demand for oil and oil prices have increased to 0.51 and -
1.94 respectively as compared to 0.39 and -1.65 in formulations (23).
Also impact of the (lagged rate of) changes of industrial production
(Y) on the rate of change of demand for oil is now significant and with
a magnitude larger (0.82) than the same coefficient at the previous
formulation. This indicates that even if in the transitory and very short
periods of time (say several months in our model) changes in
production growth would have insignificant effect on rate of changes
in oil demand, its cumulative effect in the long run could be
significant.
Generally speaking inspecting estimated model (28) will show
( 2)
that the number of ‘significant’ coefficients in Γ1 (coefficient matrix
(1)
of ∆X t −1 in equation (27)) is larger than Γ 1 (coefficient matrix of
∆X t −1 in equation (23)), but that of Π̂ matrix is not changed.
Therefore, more significant coefficients do not necessarily imply high
explanatory power, but may as well be a consequent of the
parameterization of the model (Juselius, 2003). This means that the
50 / Vol. 4, No. 12 / Spring 2007

interpretation of the estimated coefficients in dynamic models is more

complicated compared to static regression models.
In graphs below response of different variables of the model
(27) to innovations are illustrated. Larger values of statistically
significant estimated coefficients in model (27) compared to the
coefficients of model (23) are manifested in dynamics of the reaction
of the variables of model (27) to innovations. The graphs provided
below show that reactions to impulse are more vigorous and wavier in
this case implying cumulated effects of the shocks on the system of
time series variables. However, the impacts of innovations on the
VAR system require almost the same span of time to spent out as the
previous case.
The.Estimated .Model ..∆X t = Φ Dt + Γ1( 2 ) ∆X t −1 + Π X t − 2 + ε t
__________ __________ __________ __________ __________ __________ __________ __
 ∆Dt   2.12  − 0.40 .. − 0.03......0.51 ......0.82  ∆Dt −1 
∗ ∗ ∗
 ∆ P   6. 8    
 + − 0.25 .......0.05 .... − 1.94 .....1.42  ∆Pt −1  +
∗
(28)  t =
 ∆S t   2.67 ∗  
 − 0.14 ...0.013 .... − 0.17 .... − 0.39 ∆S t −1 
∗
      
 ∆Yt   − 0.24  ...0.001 ...0.02 ... − 0.002 ....... 0.06  ∆Yt −1 
∗
 − 0.42∗... − 0.002 ......0.11 .....0.15∗   Dt − 2  ε 1, t 

 ∗    
 − 0.48..... − 0.05 ... − 0.25.....0.43   Pt − 2  ε 2 ,t 
∗
 − 0.11..... − 0.001 ... − 0.12 ∗....0.06   S  + ε 

   t − 2   3, t 
 − 0.004 ......0.003∗.....0.02.. − 0.02  Yt − 2  ε 4 ,t 
1.0  0.00066 
0.05 ......1.0   
Ω= ,..σˆ ε = 0.00502 
0.75 ......0.10....... 1.0  0.00022 
   
 0 . 03 ........ 0 . 13 ...... 0 . 087 ...... 1 . 0  0.00002 
Statistics .. for .individual .. var iables .......D.......... ....... P.......... .....S .......... ...Y
R 2 .......... .......... .......... .......... .......... .......0.36.......... ..0.15.......... 0.10....... 0.10
Adj − R 2 .......... .......... .......... .......... ....... 0.32.......... ..0.10.......... 0.05 ........0.05
F − statisic .......... .......... .......... .......... ....9.26.......... .2.9.......... ..1.9.......... .1.97
Common .sample .statistics ,. Akaik .Informatio n.Criterion ( AIC ), and .Schwartz .Criterion ( SC )
ˆ = −32 .86,.. AIC = −21, ,.SC = −20
Log ( L max) = 1534 .9,..... log Ω
__________ __________ __________ __________ __________ __________ __________ __
Vol. 4, No. 12 / Spring 2007 / 51

Fig. 15. Response to Cholesky One S.D. Innovations ±S.E.

In Model (26)
in Model (26)
.03 .03
.02 .02
.01 .01
.00 .00
-.01 -.01
-.02 -.02
-.03 -.03
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10

.12
.12
.08
.08
.04
.04
.00
.00
-.04
-.04 1 2 3 4 5 6 7 8 9 10
1 2 3 4 5 6 7 8 9 10
Response of D(LS) to D(LP) Response of D(LP) to D(LY)

.015 .12
.010
.08
.005
.000 .04
-.005
.00
-.010
-.015 -.04
1 2 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
Another convenient formulation of the VAR model is in second

order difference (acceleration rates), changes and levels (see Hendry
and Juselius, 2000). It is argued that this formulation is particularly
useful when there are I(2) time series in the VAR model of concern,
but this formulation is in general more convenient representation of a
52 / Vol. 4, No. 12 / Spring 2007

VAR model when the sample contains periods of rapid changes, so

that acceleration rates (in addition to growth rates) become relevant
determinants of agents’ behavior.
So we have estimate our four variables VAR(2) model in this
formulation which in matrix form would be similar to (28):
(29) ∆2 X t = ΦDt + Γ∆X t −1 + Π X t − 2 + ε t
where.Γ = Ι − Γ1 ,.and .Π = Ι − Π1 − Π 2
The estimation results which are reported in (30) may look at
first sight quite different from the previous exercises. But in fact we
have more or less the same matrices of estimated coefficients save for
the diagonal elements of the differenced variables vector. a closer
investigation would reveal that a factor of -1 has been added to the
diagonal elements of the differenced variables. Thus, the significance
of the diagonal elements are only a consequence of applying the
difference operator once more to ∆X t . For this reason it could be
more meaningful to test whether the diagonal elements are
significantly different from -1 than from zero. The F statistics on the
significance of the regressors have obtained large values, which is just
an artifact of the ∆2 transformation, and they do not say much about
the importance of the lagged t-1 variables in explaining the variations
in Xt .
Although the above reformulations are equivalent in terms of
explanatory power, and can be estimated by OLS without considering
the order of integration, however, inference on some of the parameters
will not be standard unless X t ~ i (0 ) . For example, when Xt is not
stationary, the joint significance of the estimated coefficients cannot
be based on standard F-tests (see Hendry and Juselius, 2000). It is
worth nothing that since we have estimated the VAR model with
optimal order determined by the relevant criteria and information
statistics, according to the VARDL modeling approaches (see Pesaran
and Shin, 1997 and Pesaran et al 2001) the estimation results could be
considered efficient and consistent. Nevertheless, we would not
prolong our paper which is concluded here, and will leave the issue of
Vol. 4, No. 12 / Spring 2007 / 53

VARDL to the second part of the study to be discussed in association

with the issue of co-integration in the VAR.
The.Estimated .Model..∆2 X t = ΦDt + Γ∆X t −1 + ΠX t −2 + ε t
________________________________________________________________________
∆2 Dt  2.12  − 1.40∗.. − 0.03......0.51∗......0.82∗  ∆Dt −1 
 2      
∆ Pt  6.8  − 0.25...... − 0.95... − 1.94 .....1.42  ∆Pt −1 
∗
(30) ∆2 S  2.67 ∗  − 0.14∗....... 0.013.. − 1.17.... − 0.39  ∆S  +

= +
 t 
     t −1 
∆2Yt  − 0.24 ...0.001.......0.02∗.. − 0.002.. − 1.06∗  ∆Yt −1 
 − 0.42∗... − 0.002......0.11.....0.15∗   Dt −2  ε 1,t 
 ∗    
 − 0.48..... − 0.05 ... − 0.25.....0.43   Pt −2  ε 2,t 
∗
 − 0.11..... − 0.001... − 0.12∗....0.06   S  + ε 

   t −2   3,t 
 − 0.004......0.003∗.....0.02.. − 0.02  Yt −2  ε 4,t 
1.0  0.00066
0.05......1.0   
Ω=  ,......... ......σˆ ε = 0.00502
0.75......0.10....... 1.0  0.00022
   
0.03........ 0.13......0.087......1.0 0.00002
Statistics.. for.individual.. var iables.........D.......... .......P.......... .....S .......... ....Y

R 2 .......... .......... .......... .......... .......... .....0.75.......... ...0.52.......... 0.51.........0.54
Adj − R 2 .......... .......... .......... .......... .......0.73.......... ...0.49.......... 0.49......... 0.52
F − statisic.......... .......... .......... .......... ...51.13.......... .18.05.......17.96.......20.13
Common.sample.statistics ,. Akaik .Information.Criterion ( AIC ), and .Schwartz.Criterion ( SC )

ˆ = −32.86,.. AIC = −21, ,.SC = −20
Log ( L max) = 1534.9,..... log Ω
________________________________________________________________________
Although the above reformulations are equivalent in terms of

explanatory power, and can be estimated by OLS without considering
the order of integration, however, inference on some of the parameters
will not be standard unless X t ~ i (0 ) . For example, when Xt is not
stationary, the joint significance of the estimated coefficients cannot
be based on standard F-tests (see Hendry and Juselius, 2000). It is
worth nothing that since we have estimated the VAR model with
optimal order determined by the relevant criteria and information
statistics, according to the VARDL modeling approaches (see Pesaran
and Shin, 1997 and Pesaran et al 2001) the estimation results could be
54 / Vol. 4, No. 12 / Spring 2007

considered efficient and consistent. Nevertheless, we would not

prolong our paper which is concluded here, and will leave the issue of
VARDL to the second part of the study to be discussed in association
with the issue of co-integration in the VAR.
4. Summary and concluding remarks

In this paper we developed and estimated a four variate VAR model to
investigate dynamic of oil markets in OECCD countries. The time
period of study covers January 1995 t o March 2007 and the time
series contain monthly data on demand for oil, industrial production,
stock of commercial crude and products in OECD and WTI. Data sets
are collected from Data Service Department (DSD) of OPEC
Secretariat.
Having found the time series of the VAR model integrated of
degree one I(1), with co-integration relationships we determined the
optimal lag length of the VAR model and then estimated the
unrestricted VAR model in different representations. Estimation
results considering different formulation of the model all show clear
signs of the important effects that production (economic growth) and
also changes in stocks’ level of crude and products exert on demand
for oil and on oil prices. To be more precise we find income elasticity
of demand for oil to be in the range of 0.67 to 0.96 and proportional
changes of oil price in response to an increase of 10% in the crude and
product stocks to be between -16.5% to 19.5% in the short run. On
the other hand, in congruity with the mainstream empirical works on
oil markets we also find oil price impact on demand for oil in OECD
countries statistically insignificant and negligible in absolute term.
One particular point that emerges worthy of emphasizing, is
imperative requirement of inclusion of the crude and products’
commercial stocks time series in any modeling attempt for estimating
and forecasting oil demand and oil prices in OECD. The estimation of
the VAR model resulted in identifying evidence of a stable
relationship between the four time series of concern.
The analysis of this paper also has provided statistical evidence
Vol. 4, No. 12 / Spring 2007 / 55

supporting the hypothesis that like many economic series, demand for
oil, oil prices, industrial production and stock of crude and products
are non-stationary time series. This can have important implication
with respect to estimation, forecasting and policy analysis as not
taking into account possible non-stationarity in the data could lead to
misleading results and failing to catch important properties of the data.
While this does not mean that VAR-VEC modeling approach are
always superior to the other modeling techniques, nevertheless, VAR-
VEC analysis can provide a useful benchmark for empirical
investigation of oil markets dynamics.
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58 / Vol. 4, No. 12 / Spring 2007

Appendix
A short description of the modeling Methodology

Vector Auto-regression (VAR) and vector error correction (VEC)
modeling approaches have found wide spread application in petroleum
economics since introduction of time series analysis to econometrics
literature. As for financial and commodity markets, time series
modeling are employed to analyze developments of oil markets and to
predict changes in variables of interest in this industry. This is mainly
due to the fact that economists and econometricians have found time-
series modeling a convenient way of summarizing information given
by the data generating process (DGP) of these markets.
The use of VAR models in economics arose largely due to the
influential work of Sims “Macroeconomic and Reality,
(Econometrica, 1980). Prior to Sims’ pioneering work, economists
tended to model time series relationship as either a system of
structural equations, estimated one by one, or as on or more reduced
form equations. Sims argued quite strongly that the “incredible
identification restrictions” which are inherent in structural modeling
required an alternative estimation strategy.
One can also think of VAR modeling strategy as arising
naturally out of the seminal work of Box and Jenkins (1976) They
argued that a prudent manner to forecast the future path of any
stochastic process is to statistically model the past realization of the
variables. This lead to the explosion of autoregressive integrated
moving average (ARIMA) models. VAR analysis extends the Box and
Jenkins work to more than one variable. (Atkins 2005).
VAR models are shown to be essentially reformulations of the
co-variances of the data, (Juselius, 2003). The question, in application
of VAR modeling techniques in economic problems, is whether a
VAR model can be interpreted in terms of rational behavior of
economic agents. According to the assumption of the VAR model the
difference between the mean and the actual realization of data is white
Vol. 4, No. 12 / Spring 2007 / 59

noise process. This assumption is consistent with economic agents’

behavior that are assumed to be rational in the sense that they do not
make systematic forecast errors when they make plans for time t based
on the available information at time t-1. For example, a VAR model
with auto-correlated and or heteroscedastic residuals would describe
agents that do not use all information in the data efficiently as
possible. This is because they could do better by including the
systematic variation left in the residuals, thereby improving their
expectations about the future. Therefore checking the white noise
requirement of the residuals is not only crucial for correct statistical
inference, but also for the economic interpretation of the model as a
rough description of the behavior of rational agents (Hendry, Juselius,
2000).
One of the major advantage of a standard VAR is that all the
variables of the model are treated as endogenous (of course we could
consider exogenous variables in a VAR model as well) and right hand
side variables are pre-determined (that is non-contemporaneous , or
lagged values), we can avoid the ubiquitous problems associated with
simultaneous equation bias. In a sense we allow the data speak, by
uncovering a rich set of dynamics amongst the variables which we
consider to be important. The VAR model may be viewed as a system
of reduced form equations in which each of the endogenous variables
is regarded on its own lagged values and the values of all other
variables in the system.
The VAR methodology requires determining the appropriate
variables to be included in the VAR system (which in our example
above is three) and determining the appropriate lag length (k).
Inclusion of variables in a VAR system could be assisted by economic
theory or some prior knowledge from observations or reflected in the
literature and the latter is accomplished through the use of some
system model selection criteria, such as Akaike Information Criterion
(AIC). Obviously a typical VAR will be greatly over parameterized in
the sense that many of the coefficients will be individually statistically
insignificant.
60 / Vol. 4, No. 12 / Spring 2007

We noticed that in a standard VAR the right hand side contains

only pre-determined variables (mainly lagged variables) and the error
terms are assumed to be serially uncorrelated. Now the question is
whether we can estimates each equation of a standard VAR by OLS
without loss of efficiency? The answer is that if all the time-series of
the model were stationary then our VAR was considered a stationary
VAR and OLS technique would yield consistent and efficient
estimation results. However, most economic time series are non-
stationary and for this reason we will have to address this issue before
proceeding with the estimation exercise.
1. Stationarity
From the preceding discussion it becomes clear that a time series
analysis of oil markets would require, from the outset, verification of
the classical econometric theory assumption of stationarity of the data
generating processes representing the market of concern. These
assumptions intend that means and variances of the process are
constant over time. However, graphs of monthly data of the petroleum
markets variables for the time period under study (1995-2007) some
of which are depicted in different panels of Fig. 2 and the historical
record of economic forecasting of these variables would suggest
otherwise.
Petroleum markets evolve, grow and change over time in both
real and nominal terms, some times dramatically- and economic
forecasts of oil prices, its supply and demand are often badly wrong,
whereas forecasting failure of this magnitude should occur relatively
infrequently in a stationary process (see Hendry, and Juselius, 1999).
A significant deterioration in forecast performance relative to the
anticipated outcome confirms that petroleum markets’ data are not
stationary because even poor models of stationary data would forecast
on average as accurately as they fitted, yet that manifestly does not
occur empirically.
Figure 1 shows the four time series of the petroleum market in
OECD that we are trying to establish the relationship between them.
The first panel reports the monthly time series of demand for oil
Vol. 4, No. 12 / Spring 2007 / 61
(LDOECD) in OECD. Panel b shows industrial production

(LIPIOECD). Panel d records total stock of commercial crude and oil
products reserves (LTSOECD) and finally panel d depicts monthly
WTI in real term (LRWTI) in the time period of concern. Since the
variables are expressed in logarithmic scale therefore every graphs
show proportional changes in the respected variables: hence
apparently small movements over the time intervals sometimes
represents quite large changes. In some cases such as industrial
production index of panel b regarding the scale of the graph, much
smaller range of variation is observed in equal intervals of time, but
again, the notion of a constant mean seems untenable. In general we
can say that there is considerable evidence of changes in means of
petroleum markets’ time series and it is hard to imagine any
revamping of the statistical assumptions such that these outcomes
could be construed as drawing from stationary processes.
Fig. 1. Monthly Demand for Oil, Industria Production, WTI and
Fig. 2. Monthly Demand for oil, Industria Production, WTI
Total and Product
and Total StockStock
Oil andProduct in OECD in OECD(1995-2007)
(1995-2007)
10.90 4.72
4.68
10.85 LDOECD
4.64 LIPIOECD
10.80 4.60
4.56
10.75 4.52
4.48
10.70
4.44
10.65 4.40
1996 1998 2000 2002 2004 2006 1996 1998 2000 2002 2004 2006
Monthly Demand for Oil: OECD Monthly Industrial Production: OECD
-0.4 14.85
LTSOECD
-0.8
14.80
LRWTI
-1.2
14.75
-1.6
14.70
-2.0
-2.4 14.65
1996 1998 2000 2002 2004 2006 1996 1998 2000 2002 2004 2006
WTI in Real Term Total Commercial Stock of Crude and Products: OECD
62 / Vol. 4, No. 12 / Spring 2007

While it is quite difficult to tell, by visual examination of level

data, if a time series is non-stationary, it seems that time-series of
concerned do have characteristics consistent with non-stationary data.
All appear to have a trend and meandering quality, with variables
wandering up and down. The means of the series however, do not look
constant overtime, except perhaps for the crude and product inventory
variable, LTSOECD, and in fact may be drifting upward, suggesting
the possibility of a stochastic trend. The price series, LRWTI, also
appear to be serially correlated, with prices drifting up for a while
followed by periods of successive declines. Furthermore, the volatility
of the series vary over time. Nevertheless, variation of the time series
might be consistent with the possibility that these processes share a
common trend, fluctuating around a certain level meaning that these
time series may be co-integrated.
As Hendry and Juselius (1999) argue “the practical problem
facing econometrician is not a plethora of congruent models from
which to choose, but to find any relationships that survive long
enough to be useful”. For these reasons while in this study we try to
establish and identify the relationships between some important
variables of the petroleum markets, ignoring the fact that all or some
of the time-series of petroleum markets might exhibit non-stationarity,
could have severe consequences of spurious regressions and invalid
statistical inference undermining robustness of the forecasts of the
econometric model.
When data means and variances are non-constant, observations
come from different distributions over time, posing difficult problems
for empirical modeling. Assuming constant means and variances when
they are not can induce serious statistical mistakes.
Non-stationarity can be due to evolution of the economy,
legislative changes, technological change, and political turmoil among
other things. In practice, it is useful to classify exhibiting a high
degree of time persistence (insignificant mean reversion) as non-
stationary and variables exhibiting a significant tendency to mean
reversion as stationary. However, it is important to stress that the
Vol. 4, No. 12 / Spring 2007 / 63

stationarity/ non-stationarity or alternatively the order of integration of

variable, is not in general a property of an economic variable but a
convenient statistical approximation to distinguish between the short-
run, medium-run and long-run variation in the data (Juselius, 2003).
Econometrically it is convenient to let the definition of long-run or
short run depend on the time perspective of the study. From economic
theory point of view the question remains in what sense a “unit root”
process can be given a “structural” interpretation. For example, oil
price is considered stationary in one study and non-stationary in
another, where the latter is based, say, on a sub sample of the former
might seem contradictory. This need not be so, unless a unit root
process is given a structural interpretation. However, given the time
period of our study that at best could be regarded a medium-term time
period we could expect finding our time series non-stationary.
2. Addressing non-stationarity
As was mentioned non-stationarity is observed in economic time
series very frequently so much that it seems natural feature of
economic life. Legislative changes are one obvious source of non-
stationarity, often inducing structural breaks in time series, but it is far
from the only one. Economic growth, perhaps resulting from
technological progress, ensures secular trends in many time series.
Such trends need to be incorporated into statistical analysis. In time
series analysis of economic systems such as petroleum markets focus
usually are on a type of stochastic non-stationarity induced by
persistent accumulation of past effects, called unit-root process. Such
process can be interpreted as allowing a different ‘trend’ at every
point in time, so are said to have stochastic trends.
There are many plausible reasons why economic data may

contain stochastic trends. Economic variables depending closely on
technological progress are most likely to have stochastic trend.
Because technology involves the persistence of acquired knowledge,
so the present level of technology is the accumulation of past
discoveries and innovations. The impact of structural change in the
64 / Vol. 4, No. 12 / Spring 2007
world oil markets is another example of non-stationarity. Other

variables related to the level of any variable with a stochastic trend
will ‘inherit’ that non-stationarity, and transmit it to other variables in
turn: oil income for oil exporting countries may led to structural
changes in investment, economic growth employment and so on and
its decline might cause a significant increase in exchange rate inflation
and unemployment in these countries. In annex to this paper we have
provided an illustration of the main concepts of VAR-VEC modeling
approach.
3. Testing for Unit-Roots and Integration of the VAR model

variables
When testing stability of the system we do not need to specify the
order of integration of the model’s variables (Xt ) because, as was
discussed, as long as the parameters of the model were unrestricted,
OLS could be used to estimate them consistently. However, when we
want to set the scene for conducting an analysis based on stationary
series we will have to determine first the order of the integration of the
non-stationary series of our VAR system.
One can test formally for stationarity by testing if the variable
may be described as a random walk, either with or without drift. This
procedure is also called testing for unit root as an I(1) process has a
unit root. If we find we cannot reject the hypothesis that the variable is
a unit root (e.g. follow a random walk) then we have found that
variable is not stationary and must proceed accordingly.
It might seem that the test for stationarity is a parameter test on
the AR(1) model given its general case: X t = β 1 + β 2 X t −1 + ε t .
Specially we can test the hypothesis that β 1 = 0,.and ,.β 1 = 1 , in which
case the series is a random walk. Whilst this approach is intuitively
appealing it requires modification for the following reasons:
(i) Equation X t = β 1 + β 2 X t −1 + ε t . is a restricted version of
the general model which includes also a deterministic
time trend. So we must use a more general model such
Vol. 4, No. 12 / Spring 2007 / 65

as: X t = β 1 + β 2 t + β 3 X t −1 + ε t as the basis for our initial

testing.
(ii) It can be shown that if the series is non-stationary then
the estimate of β 3
will be downward bias. For this reason we cannot use the
standard t-or F statistics when looking at critical values
to conduct significant tests. Alternative critical values
have been provided by Dickey and Fuller.
(iii) A modified Version of the equation
X t = β 1 + β 2 t + β 3 X t −1 + ε t is used called the
Augmented Dickey –Fuller (ADF), which includes the
lagged difference of the variable.
X t = β 1 + β 2 t + β 3 X t −1 + β 4 ∆X t −1 + ε t ; the inclusion of
this term means that the critical values are valid even if
there is residual autocorrelation.
4. From Co-integration Relationships to Error Correction

Models
Co-integration analysis is inherently multivariate, as a single time
series cannot be co-integrated. Consequently, in a set of integrated
variables, such as crude oil demand and its price, level of crude and
product inventory, where each process is individually I(1), but follows
a long-run path, affected by industrial production, co-integration
between these variables could arise, for example, if there was a linear
combination of these variables constructing a stationary process.
However, co-integration as such does not say anything about the
direction of causality. So if the assumptions about these relationships
directions were incorrect, then the estimates of the co-integration
relations would be inefficient, and could be biased. To find out which
variable adjust and which variable do not adjust, to the long-run co-
integration relations, an analysis of the full system of equations is
required (Hendry, Juselius, 2000)
From the last section it became clear that the remedy for a unit
66 / Vol. 4, No. 12 / Spring 2007

root would be to estimate the VAR in first difference form. However,

many economists and econometricians (see for example: Sims,(1890),
Sims, Stock and Watson, Econometrica, (1990), Hendry and
Juselius(2000)), argue against differencing even if the time series that
do contain a unit root are difference stationary. The main point against
the procedure of differencing time series to reach stationarity is the
loss of information related to the long run relationship between the
variables, in the process. This potential problem of losing information
leads to the concept of an error correction model, which bears a very
close relationship to a VAR methodology.
5. Uncovering the Dynamics

A Vector Auto-Regression system and closely related Vector Error
Correction model possess a very rich set of dynamics which
uncovered through the use of impulse response functions. It is well
known that any single variable auto-regression has a moving average
representation. Therefore, a natural generalization of this is that any
VAR (or respected VEC) models have a vector moving average
(VMA) representation. For example if we had a VAR system
consistent of four endogenous variables, it can be shown that one can
arrive to a VMA by necessary manipulation of the four variables VAR
model. There is an analogous VMA for the VEC model. The 16 sets
of coefficients φij (i ) in our VAR model are the impulse response
functions. These give us the effect of the shocks ε 1t ,.ε 2t ε 3t and ε 4t on
the entire time paths of the entire sequences of {X1t}, {X2t},{X3t}and
{X4t}. Notice that for i=0, the coefficients give the impact response.
Of interest in this study is the elasticity of response of one
variable to another. This can be calculated as the dynamic correlation.
This would give us the time path of the elasticity. It should be noted
that analysis using the impulse response function is completely
analogous to forecasting. In an impulse response function framework,
if we shock one variable, say P, and trace the response of another
variable say D, in fact we are forecasting the future path of D, given
some future values of P.
Vol. 4, No. 12 / Spring 2007 / 67

6. Model selection
The most difficult aspect of working with time series data is model
selection. The crucial point to understand is setting up models in terms
of components which have a direct interpretation. This enables the
researchers to formulate, at the outset, a model which is capable of
reflecting the salient characteristics of the data. Once the model has
been estimated, its suitability can be assessed not only by carrying out
diagnostic tests to see if the residuals have desirable properties but
also by checking whether the estimated components are consistent
with any prior knowledge which might be available. Thus for
example, if a cyclical component is used to model the oil trade cycle,
knowledge of the petroleum economics history of the period should
enable one to judge whether the estimated parameters are reasonable.
This is in the same spirit as assessing the plausibility of a regression
model by reference to the sign and magnitude coefficients.
Classical time series analysis is based on the theory of stationary
stochastic process, and this is starting point for conventional statistical
time series model building. It can be shown that most stationary
process can be approximated by a model from the class of
autoregressive moving average (ARMA) models. However, a much
wider class of models, capable of exhibiting non-stationary behavior,
can be obtained by assuming that a series can be represented by an
ARMA process after differencing. This is known as the autoregressive
integrated moving average (ARIMA) class of models and a model
selection strategy for such models was developed by Box and Jenkins
(1976).
The following criteria for a good model have been proposed in
the econometrics literature. (Hendry and Richard(1983), Mizon and
Richard(1986), Ericson and Hendry (1985) Mizon(1984) and
Haevey(1981a). They apply to both structural time series and pure
time series modeling.
(a) Parsimony A parsimonious model is one which contains a
relatively small number of parameters and other things being
equal, a simpler model is to be preferred to a complicated one.
68 / Vol. 4, No. 12 / Spring 2007

(b) Data coherence Diagnostic checks are performed to see if the

model is consistent with the data. The essential point is that the
model should provide a good fit to the data, a the residuals, as
well as being relatively small, should be approximately
random.
(c) Consistency with prior knowledge In an econometric model,
economic theory may provide prior information on the size or
magnitude of various parameters and the estimated model
should be consistent with this information.
(d) Data admissibility A model should be unable to predict values
which violate definitional constraints. For example many
variables cannot be negative,
(e) Structural stability As well as providing a good fit within the
sample, a model should also give a good fit outside the sample.
In order for this to be possible, the parameters should be
constant within the sample period and this constancy should be
carry over into the post-sample period.
(f) Encompassing A model is said encompass a rival formulation
if can explain the results given by the rival formulation. If it is
the case, the rival model contains no information which could
be used to improve the preferred model.
We have tried to observe most of these criterions in our
exercise, however, it remains to be seen whether these criteria are
satisfied in our time-series modeling exercise. A pure time series
model contains no explanatory variables apart from variables which
are solely functions of time. Forecasts of future observations are
therefore made by extrapolating the components estimated at the end
of the sample. Since the forecasts are based on a statistical model, the
mean square errors (MSE) associated with them may be computed.
When a model contains explanatory variables, forecasts can only
be made conditional on future values of these variables. If lagged
values of an explanatory variable enter into a model, some of the
values which are needed to generate forecasts of the dependent
variable are known and the explanatory variable is then referred to as
Vol. 4, No. 12 / Spring 2007 / 69
a leading indicators.
A multivariate time series model offers the possibility of
allowing for interactions among the variables when forecasts are
made. As with univariate time series modeling, the effectiveness of a
multivariate model depends on the extent to which it remains stable
over time.
Having reviewed the main features of the VAR modeling
approach in context of our empirical study of the oil market dynamics
in OECD we now turn to specify the VAR model outline of which
was discussed above briefly.
70 / Vol. 4, No. 12 / Spring 2007

Allocation of CO2 emissions in

petroleum refineries to petroleum
joint products: a case study
Alireza Tehrani Nejad M.1

Valérie Saint-Antonin2
Abstract
Oil refining is a joint production system because the production of one
oil product makes technically inevitable the production of other oil
products. Due to the complex nature of the process involved and the
vast number of joint product outputs that are strongly correlated, it is
very difficult to establish any meaningful CO2 emissions allocation
between oil products. Nevertheless, the allocation of petroleum
refinery energy use and the resultant CO2 emissions among different
oil products is necessary in “well to wheel” analysis in order to
evaluate the environmental impacts of individual transportation fuels.
In practice, allocation methods used so far for the petroleum-
based fuel are traditionally based on two fundamental approaches:
physical measures (mass, volume, energy contents or other relevant
parameters) or market value of individual oil products from a given
refinery. These methods are open to discussion on two points. Fist, an
a priori assumption about the allocation procedure (i.e., mass, volume,
energy contents, market value, etc.) is in some ways completely
1. alireza.tehraninejad@gmail.com
2. valerie.saint-antoni@ifp.fr
Vol. 4, No. 12 / Spring 2007 / 71
arbitrary and consequently of little use for economic decision making

purposes. Second, these approaches ignore the opportunity cost effects
and the interdependencies which might exist among the refinery
process units, and systematically assign more emissions to the oil
products that utilize more process units.
More sophisticated proposals to energy consumption and
emissions allocation have been developed based on the concept of
duality in linear programming (LP). Unfortunately, in refinery LP
models constraints on (fixed) unit process capacities or input
availabilities might destroy the additivity property of the marginal-
based allocations. In fact, due to a technical feature inherent in LP, the
petroleum product allocation coefficients might underestimate or
overestimate the total volume of the refinery’s CO2 emissions. This
handicap is a valid objection to LP as an allocation tool in
retrospective or accounting LCA studies and might limit its use for
problems in which the objective is to assign unambiguously the whole
refinery’s emissions among the oil products.
This practice-oriented paper is aimed to provide a two-stage
procedure, based on LP, to fully allocate the refinery’s CO2 emissions
among the refinery’s petroleum joint products. The procedure is
applied to the IFP (Institut Français du Pétrole) oil refinery. The
average contribution of petroleum oil products to the refinery’s CO2
emissions are then compared with the other accounting allocation
methods. We show that, contrary to these latter, gasoline has not
always a higher average CO2 content than that of diesel within the
European refineries.
Key words: Co2 emission, refineries, well to wheel emission, joint

products.
1. Introduction
Life Cycle Assessment (LCA) is one of the engineering methods that
has increasingly gained attention and is regarded today as an
important tool for environmental policy and strategic decision making.
72 / Vol. 4, No. 12 / Spring 2007

According to the Society of Environmental Toxicology and Chemistry

(SETAC, 1993), this method aims at evaluating the environmental
burdens associated with a product, process or activity throughout its
life cycle from the extraction of raw materials through processing,
transport, use, disposal and recycling. By relating environmental
issues to the whole production chain, this method is regarded to have a
holistic system-level approach which is well suited for assessment of
complex systems.
Well-to-Wheel (WTW) studies are similar to LCAs but they
cover a narrower system boundary by only focusing on the transport
applications. They calculate the energy consumption and the
associated greenhouse gas emissions along fuel chains and consist of
two parts. The first part assesses the stage from the extraction of
feedstock until the delivery of automotive fuels to the vehicle tank and
is usually referred to as Well-to-Tank (WTT) analysis. The second
part corresponds to Tank-to-Wheel (TTW) studies and aim at
evaluating the performance of automotive fuels in the engine.
By analogy to LCAs, WTW studies can be also categorized in
retrospective and prospective approaches (e.g., Ekvall et al., 2005).
Retrospective studies look back at historic environmental impacts and
use plant-specific or average data to illustrate the environmental
burdens (e.g., CO2 emissions) associated with the average production
of a given automotive fuel.
These kind of studies are useful for environmental accounting
purposes. On the other hand, prospective or change-oriented studies
look forward and consider the effects of different decisions. They are
based on marginal data and attempt to explore the environmental
effects associated with the marginal production of a given automotive
fuel. As mentioned by EUCAR et al., (2004), when the ultimate
purpose of a study is to guide the policy makers, prospective or
marginal approach should be considered. In this study, we focus on
both retrospective and prospective WTT analysis.
Since in WTT studies the main difference among the CO2
content of automotive fuels are exclusively due to the refining process
(EUCAR et al., 2004), especial care should be taken on this
Vol. 4, No. 12 / Spring 2007 / 73

component. Oil refining is a joint production system with a very

complex technical structure and a vast number of outputs that are
strongly correlated. Therefore a key methodological problem which
inevitably arises is how to correctly identify and quantify the real
cause-effect chains that should be considered in estimating the
marginal and aver-age CO2 content of automotive fuels at the gate of
the refinery1 within refineries. Neither the traditional WTT
approaches, nor the existing databases can be useful because they fail
to capture the complex interdependencies and synergies which exist
among the refinery oil products and process units.
This paper attempts to illustrate that a practical way to perform such
an analysis is to use Linear Programming (LP) models. In contrast to
the traditional WTT methods, the information created through the
duality in LP incorporates the complete interdependency and
economic effects associated with any marginal variation in the
refinery; these information can be directly used for prospective WTT
studies but need some more computations for retrospective analysis.
The proposed methodology is then applied to a real-type refinery
model in order to estimated the CO2 content associated with the
marginal and average production of the automotive fuels. Three
simulations for years 2005, 2008 and 2010 are performed to evaluate
the impact of the sulfur tightening policy on the CO2 content of
automotive fuels at the gate of the refinery. This question is of
importance because the reduction of the environmental impacts of
automotive fuels constitutes one of the prime objectives of the
European environmental policies.
2. General Linear Model of the Refinery and the CO2

Emissions
The use of LP in the refining industry spans a period of well over 50
years. The blending of gasoline was among the first popular
applications of LP in refineries (Charnes et al., 1952). Today,
1. Throughout this paper, by marginal (average) CO2 content of a given oil product we mean
the additional CO2 emissions associated with the marginal (average) production of that oil
product within the refinery.
74 / Vol. 4, No. 12 / Spring 2007

designing new units, fixing the operating conditions, making a choice

of feedstocks, improving the operations planning, oil product costing,
policy analysis and forecasting are among the routine utilization of LP
in oil refineries.
Refineries are very large complex industrial plants converting
crude oil to a large number of petroleum products. Here, we develop
the following static single-refinery LP model which operates in a
competitive environment.
min cT x

s.t.
 Ax ≥ b (product demand constraints)
 (material balance and quality constraints)
(1) Dx = 0
Ex − ε = 0 (CO2 balance equation)
 (capacity constraints)
Fx ≤ f
x ≥ 0, ε ≥ 0.

The main variables of our model are non negative physical
flows xj (j =1, 2,...,n) between refining units from crude oils to end-
use oil products along with intermediate products, utility
consumptions, exchange products and pollutant emissions. The term c
is the given n-vector of acquisition input costs and includes the cost of
crudes, feedstocks, operating variable cost (e.g., cost of catalysts,
solvents and chemicals) and the exchange cost of finished products. In
a cost minimizing framework, the refiner’s objective is to satisfy
demand for a product (in terms of both quantity and quality), denoted
by the m-vector b, at minimum cost subject to the prevailing
technology, input costs and availability. The oil product categories
considered in this model are liquefied petroleum products (propane
and butane), naphtha, gasoline, middle distillates (jet fuel, diesel and
heating oils), heavy fuel oils with 1% and 3.5% mass sulfur contents
and bitumen.
The linear technology used is represented by the fixed
coefficient matrix A of dimensions m × n. The most common types of
other constraints are the material balance and product quality
Vol. 4, No. 12 / Spring 2007 / 75

constraints. The latter guarantee the expected quality and technical

requirement of finished products in blending problems such as octane
number (for gasoline), cetane number1 (for diesel), viscosity (for fuel
oil) and sulfur content (for all the above products). The material
balance constraints represent the fact that the sum total of quantities
going into some unit process or blending pool equals the sum total
coming out. These constraints are represented in a standard form by
the block Dx = 0.
We have also defined an emission balance equation, Ex,
capturing the numerous source of CO2 emissions in the refinery. In
general, a refinery’s emissions depend on the crude oil’s weight
(API2) and the conversion degree required for achieving the oil
production target b: a high share of more valuable products (i.e.,
gasoline and diesel) requires higher processing and more CO2
emissions. Modern and more complex refineries that are equipped to
process heavier crude slates and produce lighter products record
higher CO2 emissions. Different types of fuels are burnt to provide the
required energy for refining processes. In our LP model, the total
carbon dioxide emissions ε are generated from burning fuel gas
(ethane and propane), liquefied fuel (e.g., vacuum residue) and the
coke of the catalytic cracker, each of which being assigned a specific
CO2 emission coefficient E of dimension 1 × n.
Finally, since our study concerns the short and medium term the
availability of some process units is limited to their installed capacity
in the short term, Fx ≤ f . That is, no invest-ment occurs in new
technology and no capital investment is depreciated or retired. For the
medium term simulations, however, some realistic investments could
occur.
For a general solution, let M and S be the sets of active demand
constraints and scarce unit processes at the optimum. In words, the
1. The cetane number measures the speed at which diesel burns in an engine when subjected
to high temperature and pressure (Favennec, 1998).
2. The degree API is an arbitrary scale for the measurement of the density of crude oil. The
relationship between relative (with respect to water) density and degree API is given by the
formula: °AP I = 141.5/d −131.5 (Favennec, 1998).
76 / Vol. 4, No. 12 / Spring 2007

optimal combination of inputs are such that all final product demands
are satisfied without any excess of production. This assumption is
justified within a static LP model in which no inventory or exportation
variable is defined. Moreover, we denote Β the (k × k) basic matrix
and β the set of basic index. Sections 3 and 4 describe how the optimal
LP solution could be used in order to yield non arbitrary prospective
and retrospective WTT information.
3. Prospective LP-based emission coefficients

The exposition of this approach in this paper differs from the existing
literature known as the marginal allocation methodology (see
Azapagic and Clift, 1994, 1995, 1998, 1999a,b; Babusiaux, 2003).
Following the definition of a primal feasible basic variable,
b 
(2) 0
xB = B −1  
0
 
f −1
where xB represents the vector of basic variables and B
corresponds to the inverse of the basis (a matrix) which is pre-
multiplied by the right-hand-side (RHS) vector. At the optimum, the
emission variable ε is always positive and can be expressed as
follows,
b 
 
T −1  0 
(3) ε = eε B
0
 
f
where eε is the ε th unit vector ( eεt = 0 for t ≠ ε and eεε = 1 ) and
eεT B −1 corresponds to the row of B −1 associated with the basic CO2
variable ε. Simplifying (3), we get:
(4) ε= ∑ α i bi + ∑ γ j f j ,
i∈M j∈ S
Vol. 4, No. 12 / Spring 2007 / 77

where α i and γ j correspond to the blocs which relate ε respectively to

the demand and capacity slack variables in the final simplex tableau.
According to the optimal technology, α i and γ j can be positive,
negative or zero (see Section 6.2). In economic words, relation (4)
implies that when the production functions Ax = b are linear
homogeneous and exhibit constant return to scale, the attribution of
the carbon dioxide emissions to primal constraints (i.e., oil products
and limiting unit processes) according to their marginal contributions
(i.e., α i and γ j ) is exactly equal to the whole CO2 emissions
generated within the refinery. The partitioned emissions reflect the
underlying technical interdependencies embodied in the re-finery
model and are not necessary in proportion to physical measures (e.g.,
mass or energy content, etc.).
To better appreciate the use of these product-related coefficients
a i (i ∈ M ) in WTT studies, we differentiate the emission balance
constraint with respect to bi as follows
 dx
 dε
(5) ∑ Ek  k
 − = 0,
k ∈β  dbi
 db{i
k ∉ε αi
where the row-vector Ek corresponds to the input-emission
coefficients as they appear in the basic index β. The vector (dxk/dbi)
represents the inverse of the marginal production of the kth unit
process with respect to the ith oil product. As shown in (5), the
α i (i ∈ M ) is calculated by tracking emissions through individual
active unit processes xk (k ∈ β ) and is adjusted by the inverse of the
marginal production vector. Thanks to this vector, the complex
substitution and synergy effects among crude oils, active unit
processes and various intermediate and final oil products are also
captured in the computation of each α i (i ∈ M ) . In other words, these
product-related coefficients1, as opposed to the ones in traditional
methods, include all consequences of the desired change on the
1. We borrowed these terminologies from Azapagic and Clift
78 / Vol. 4, No. 12 / Spring 2007

operation of the refinery as well as compositional changes of the oil

products. Therefore, these simplex-based substitution coefficients are
well suited for assessment of the marginal CO2 content of automotive
fuels for prospective WTT studies.
Similarly, γ i ( j ∈ S ) refers to the quantities of CO2 attributable
to the last unit of the jth scarce capacity process. These marginal
process-related emissions are also useful in prospective WTT studies
where the implications of both final products and unit process
expansion are of interest (Azapagic and Clift, 2000).
4. Retrospective LP-based emission coefficients

Retrospective WTT studies aim to assess the environmental burdens
(specially the CO2 emissions) associated with the average production
of a given automotive fuel within the refinery. As opposed to the
prospective approach, retrospective WTT studies require the
allocation of the total CO2 emissions of the refinery over the
petroleum products. As mentioned before, oil refining is a joint
production system and due to the complex nature of the process
involved and the vast number of joint product outputs that are strongly
correlated, it is very difficult to establish any non-controversial
allocation scheme for oil products.
In the allocation theory, it is well-known that any theoretically
justified or non-arbitrary allocation method should be additive,
unambiguous and defensible. The additivity property requires that the
total refinery CO2 emissions be equal to the sum of the parts, meaning
that all of the refinery’s carbon dioxide emissions are allocated among
the oil products, no more no less. The unambiguity condition requires
the uniqueness of the allocated parts, and the defensibility criterion,
which is the most important one, needs to provide conclusive proof for
choosing a particular allocation method among all possible
alternatives. Moreover, the allocation procedure should also take into
account the ISO 14041 recommendations which could be summarized
as follows (Frischknecht 2000):
1. Where allocation cannot be avoided, the system inputs and
outputs should be partitioned between its different products or
Vol. 4, No. 12 / Spring 2007 / 79
functions in a way which reflects the underlying physical

relationships between them;
2. Where physical relationships alone cannot be established or
used as the basis for al-location the inputs should be allocated
between the outputs and functions in a way which reflects
other relationships between them (e.g., physical measures or
economic relations).
In practice, most of the allocation rules used so far for the
petroleum-based fuel are traditionally based on two fundamental
approaches: physical measures (mass, volume, energy or exergy1
contents, molecular mass or other relevant parameters) or market
value (gross sale value) or expected economic gain of individual oil
products from a given refinery. Both of these approaches inevitably
involve the use of arbitrary allocation rules and correspond to the
second recommendation of ISO 14044. Furthermore, these approaches
provide an incomplete picture of the whole system as they ignore the
complex interactions, interdependencies and synergies which exist
among the refinery oil products and process units.
In this section we provide an original two-stage approach to
yield some LP-based coefficients in such a way that it best satisfies
the desired characteristics of a non-arbitrary allocation method as well
as the ISO 14041 recommendations. To this end, let us first observe
that in relation (4) due to the presence of the active capacity
constraints at the optimal solution the refinery’s CO2 emissions ε are
inevitably shared between both oil products and scarce unit processes.
Therefore, the product-related coefficients α i (i ∈ M ) derived from
relation (4) does not respect the additivity criterion required for an
allocation rule and can not be directly used in retrospective-oriented
studies. For instance, in a LP-based refinery case study, Tehrani Nejad
M. (2007b) observes that the total allocated CO2 to the petroleum
products based on their respective marginal contents α i (i ∈ M ) might
1. The exergy content of a system indicates its distance from the thermodynamic equilibrium.
The higher the exergy content, the farther from the thermodynamic equilibrium (definition
from, http://www.holon.se/folke).
80 / Vol. 4, No. 12 / Spring 2007

be 3.5 times more than the total unallocated CO2 emissions due to the
total process-related emissions, i.e., ∑ j γ i f j .
Achieving retrospective LP-based coefficients requires the
reassignment of the total process-related emissions over the oil
products. We achieve this objective within a two stage procedure from
the optimal emission function in relation (4) (For a complete
discussion and a numerical example, see Tehrani Nejad M., 2007a). In
this regard, care should be taken not to fall in the realm of any
arbitrary or ad hoc measures.
4.1 First stage

For some technical reasons that will be discussed in the second
stage, we begin the first step by introducing an artificial constraint into
model (1) which can be readily interpreted as a material balance
constraint for the process loss. In fact, this constraint might already
exist in most refinery models in order to capture the quantity of total
process loss. In cost accounting systems, process loss is usually
expressed as a percentage of the input activity volume. The new LP
model takes on the following specifications
min cT x

(6) s.t. Ax ≥ b
 lT x − l = 0

 ET x − ε = 0
 Fx ≤ f

 x ≥ 0, l ≥ 0, ε ≥ 0.
where the n-vector l = [l1 , l 2 ,..., l n ]
T
represents the loss
coefficients for each input activity, and the variable l measures the
total losses inherent in the production process. We also assume that
there is no abnormal loss so that e T A j + l j = 1 for all input activities,
where e T = [1,1,...,1] .
The concept of the process-related emissions γ i ( j ∈ S ) and their
technical connection with the oil products are key to our analysis. For
Vol. 4, No. 12 / Spring 2007 / 81

any j ∈ S , γ j can be formulated by differentiating the emission

balance constraint in (6) with respect to xj as follows
 dx k  dε
(7) ∑ E 
K
−
 dx
= 0,
K ∈β
K ≠ε
 dx j  {j
=γ j
Where the vector Ek corresponds to the emissions row in B, from

which the (-1) coefficient associated with ε is omitted; and, the vector
−1
(dxk dx j ) corresponds to the column of B associated with the slack
variable of the jth scarce unit process, from which γj is extracted. In
economic terms, (dxk dx j ) represents the vector of marginal rates of
technical substitution (MRTS) between the jth scarce unit process and
all the unit process activities involved in the production plan. More
precisely, this vector shows the rate at which basic inputs should be
substituted along the given oil product isoquant b, whenever an extra
unit of jth scarce input were made available at the optimum. For
notational convenience, we set (dxk dx j ) = ς j . These marginal
coefficients are a powerful tool to capture the technical characteristics
between unit processes and oil product outputs at each stage of the
refining process. To the best of our knowledge, and surprisingly, these
coefficients have never been used in any empirical LP study.
Now to reveal the physical relationships between the marginal
CO2 content of jth scarce unit process and final oil products, we
introduce the optimal adjustment of final outputs (oil products and
losses) into relation (7), which leads to
 
(8) γ i = ∑ E K  ∑ aik + lk ς jk
k ∈β  i∈ M 
k ≠ε
where, by construction, ∑ i ∈M
aik + lk = 1. To separate the part of
each output in γj, we introduce the following (k−1)×(k−1) allocating
matrix Ωi and Ω l :
82 / Vol. 4, No. 12 / Spring 2007

Ω i = diag ( aik , i ∈ M , k ∈ β , k ≠ ε )
(9) 
Ω l = diag (lk , k ∈ β , , k ≠ ε ),
Where the coefficients aik are the average productivity of crude oils
associated with the I th row of B. Similarly, the coefficients lk
correspond to the loss coefficients associated with the material balance
row for losses in B.
Using definition (9), relation (8) can be rewritten as
(10) γ j = EBT ( ∑ Ωi + Ω l )ς j
i∈M
Where construction, ∑ i ∈M
Ωi + Ω l = diag (1, 1,..., 1)
Rearranging (10), we sp separate the part of oil product outputs
from process loss in γj.
part of oil products
part of loss
64748 6 474 8
(11)
γ j = ∑ EBT Ωiς j + EBT Ω lς j .
i∈M
Relation (11) relates each γj to the refinery's outputs (including the
process losses) through a realistic technical relationship which
emerges from the equilibrium behavior of the firm.
Now, using the decomposition relation (11) and doing some
algebraic manipulations the optimal emission function (5) can be
expressed as
αi θ 4
6447 448 647 8
(12) ε =∑ (α i + ∑ E B δ ij )bi + (∑ E B δ lj )l.
T T
i∈M j∈S j∈S
The economic interpretation of relation (12) runs as follows: at

the optimal solution of model (6), the carbon dioxide emissions of the
refinery is quasi fully allocated among the oil products through their
marginal contributions α i and the production elasticity δ ij of the scarce
unit processes. The obtained (re)allocation coefficients α i depend
totally upon the technical and physical relationships that define the
operating state of the refinery and its associated cost efficient
Vol. 4, No. 12 / Spring 2007 / 83

equilibrium and accounts for all interdependencies in the production

plan.
From relation (12), we observe that a rather small residual part
remains still unallocated to the oil products, i.e., θ l . We define the
relative error term of the first step by є = θ l / ε , which is essentially
proportionate to the normal loss coefficients. While in almost real-
world refinery production models the loss coefficients are small, the
relative error of this first step should be very small too. So in
empirical studies, α i is a good estimator of the average contribution of
the ith oil product to the refinery’s CO2 emissions and the reallocation
procedure can be successfully stopped here. In the following
numerical simulations in Section 6, the allocation procedure is stopped
at the end of the first stage.
4-2. Second step

The problem considered in the second step is how much of θ l should
be shared by each product. In effect, this stage is of importance in
models in which the loss coefficients associated with some unit
processes are relatively high.
The quantity of the refinery loss l is a basic variable (because
always positive) and can be allocated among the primal constraints in
the same way as we did for the emissions variable
ε . By an analogous logic to that developed in the first step, we
decompose the loss variable l of the LP model (6) according to the
optimal basic variable definition:
b 
 
(13) T −1  0 
l = el B
0
 
f
where el is the l th unit vector ( elt = 0 for t ≠ l and ell = 1 ) and
elT B −1 corresponds to the row of B-1associated with the basic variable
l and contains several blocks referred to the slack variables of model
(6). Rewriting (13), we get the following relation
84 / Vol. 4, No. 12 / Spring 2007
(14) l = ∑ ϑi bi + ∑ υi f j ,
i=M j∈S
that relates the total process loss of the refinery to the oil
products b and the limited (fixed) unit processes x through the
marginal allocation coefficients, ϑi (i ∈ M ) and υi ( j ∈ S ) .
Relating the refinery loss to solely oil products needs
reallocating the loss contribution of scarce unit process over oil
products. By analogy to γ j , the marginal coefficient υ j can be
formulated by differentiating the loss constraint in (6) with respect to
x j as follows
 dx  dl
(15)
∑ lk  k  −
 dx  dx
= 0,
k∈β
k ≠l
 j 
{ j
=υ j
where the vector lk corresponds to the loss row in B, from which the (-
dxk
1) coefficient associated with l is omitted. The vector ( )
dx j
corresponds to the column of B −1 associated with the slack variable of
the jth scarce unit process, from which υ j is extracted. For notational
dxk
convenience, we set ( ) = ς~j .
dx j
By using the same procedure as the first stage, relation (15) can
be rewritten as
~
(16) υ j ≈ lBT ( ∑ Ωi )ς~j
i∈M
~
where the (k − 1) × (k − 1) allocating matrix Ωi is defined as
(17) ~
Ωi = diag (aik , i ∈ M , k ∈ β , k ≠ l),
ϑ
6447i 448
With ∑i∈M (ϑi + ∑ lBT δ ijn )bi .
j∈S
An exact reallocation scheme for υi ( j ∈ S ) requires normalizing
the input-output coefficients associated with each column of the
Vol. 4, No. 12 / Spring 2007 / 85
~
υ j = lBT ( ∑ Ωin )ς~j
i∈I
matrix A, so that for any j ∈ β , eT Anj = 1 . While the loss coefficients

are relatively small, the required normalization condition does not
skew the CO2 reallocations. Note that, in the first step, the material
balance constraint for the process losses plays a “justified”
normalization role and let us extract the maximum information from
the technical data that are put into the model. The relation (16)
becomes then,
~
(18) ∑i∈M Ωin = diag (1,1,...,1).
where
Using relation (18) and making some algebraic manipulations, the
optimal loss respond function becomes
ϑi
6447 448
(19) l = ∑ (ϑi + ∑ lBT δ ijn )bi ,
i∈M j ∈S
where the expression δ ijn corresponds to the production elasticity of

the jth scarce unit process at the optimum.
At this stage, we are finally ready to extract the exact average
contribution of each oil product to the refinery’s carbon dioxide
emissions. By using the relation (19) in (12) and simplifying, we get
(20) ε= ∑ (αi + ∑ EBT δ ij + θ ϑ )bi.

i∈M j∈S
144 4424444
3
α iA
In relation (20), the expression ∑ j ∈S

EBT δ ij + θ ϑi represents the
net contribution of the ith oil product to the process-related carbon
dioxide emissions (i.e., ∑ j∈S γ j f j in relation 4). These net
contributions are based on the production elasticity of the unit
processes involved in the production plan and vary following the
optimal technology of the multi-product refinery.
Let us re-state the meaning of relation (20) as follows: in a
86 / Vol. 4, No. 12 / Spring 2007

competitive situation and within a linear production technology Ax =

b, the whole CO2 emissions of the refinery can be fully assigned to the
oil products through the “average allocation” coefficients α iA (i ∈ M ) .
These latter include the direct and the indirect contribution of each oil
product to the refinery’s CO2 emissions. The direct contribution
ai corresponds to the marginal CO2 content of the ith oil product and
is directly obtainable from the final Simplex tableau as explained in
Section 3. The indirect contribution, ∑ j∈S EBT δ ij + θ ϑi , depends upon
the production elasticity of unit processes and should be calculated,
ex-post, at the optimal solution of the LP model. Note that both the
direct and indirect contributions, (i) are based on the same cost
efficient equilibrium (i.e., they are extracted from the same final
simplex tableau) and are perfectly coherent with each other; and, (ii)
they depend totally upon the technical and physical relationships that
define the operating state of the refinery and are perfectly consistent
with the ISO 14044 recommendations.
Furthermore, if we suppose that θ ϑi = 0 in relation (20), then
one could conclude that for each oil product, the percentage deviation
of average CO2 contents from marginal CO2 content must be directly
proportional to its production elasticity of supply. Note that, relation
(20) is based on any exogenous information and can be easily
computed from the optimal simplex tableau.
5. General framework and data of the refinery LP

model
The refinery model retained here is based on the LP model presented
in (6) and corresponds to a typical European Fluid Catalytic Cracking
(FCC) refinery developed by Institut Français du Pétrole. It contains
650 constraints and more than 1800 variables. Its general framework
can be summarized as follows.
5-1. Crude oil supply

Several dozen of different crude oils with different physical
Vol. 4, No. 12 / Spring 2007 / 87

characteristics are daily processed in European refineries. Because the

size of a LP model is approximately proportional to the number of
crude oils considered, it is impossible to represent all of them in a
refining model (Babusiaux et al., 1983). In this study, the number of
crudes is reduced to Brent (generic name for North Sea sweet crude
oil), Arabian Light and Arabian Heavy crudes1. However, due to
aggregation problems and the lack of complete technical information,
the optimal crude structure deduced from the LP model could not
reflect the given European oil market structure. For this reason, the
crude oil shares have been fixed in the model (see Table 1).
In addition to crude oils, a variety of other specialized inputs
such as partly refined oil products or imported residual fuel oils,
enhance the refiner’s capability to make the desired mix of products.
For simplification purposes, we only considerd some imported
feedstocks of atmospheric residue type as input to a vacuum
distillation unit. Moreover, the use of natural gas is also modeled for
meeting the refinery fuel’s specifications and producing hydrogen
from a steam reforming unit. The natural gas price used is 6.33
$US/MTBU which corresponds to its average price in year 2005
(source: World Gas Intelligence, 2005).
Table 1. Typical crude oil in the LP model
Crude oil %mass API* Sulfur content* (% mass)
Brent 40 37.0 0.32
Arabian light 40 33.0 1.86
Arabian heavy 20 27.0 2.69
Feedstocks 16.0 3.23
* Source: Favennec, 1998
5-2. Crude oil prices

The selling price of crude oils is a Custom-Insurance-Fret (CIF) price
which is deduced from the Free-On-Board (FOB) price in two steps.
First, a freight cost calculated according to a reference scale is added
to the FOB price. Then the obtained price is multiplied by an
1. These are considered to be typical of the quality of crudes currently available in European
refineries (Saint-Antonin, 1998).
88 / Vol. 4, No. 12 / Spring 2007

insurance and commission rate. Here, we used the average CIF prices
for year 2005 (Table 2).
5-3. Refinery Scheme

The refinery configuration used in this paper corresponds to the most
commonly found process scheme arrangements in Europe; that is a
typical fluid catalytic cracking refinery which is mainly oriented to
produce gasoline. Below, we briefly review the main process units.
a
Table 2: Crude oil prices for year 2005
Conversion
Crude oil $/b $/t
factorsb
Brent 7.50 53.3 400
Arabian light 7.32 49.2 360
Arabian heavy 7.10 45.9 326
Feedstocks 7.32 40.9 300
a
Source: Platt’s, 2005
b
Conversion factors from ton to barrel
The first standard process is the topping unit, in which crude oils
are distilled at atmospheric pressure and separated into various
fractions according to their boiling points. Light fractions (with a
boiling point lower than 180°C) are used to make light petroleum gas
(i.e., propane and butane), naphtha and gasoline whilst middle
fractions (distilled between 180 and 360°C) contribute to the
production of jet fuel and diesel oil. Straight-run cuts can not be used
directly to blend pools since their characteristics are too far from end-
product specifications.
Various process units operate in order to improve these
intermediate products. In particular, acatalytic reforming unit
upgrades the heavy naphtha cut into an aromatic gasoline component
with significantly higher octane numbers. This unit provides, as a
precious by-product, the hydrogen required for the hydro-treating and
desulfurization units. Moreover, two different isomerization units are
also modeled to convert n-paraffins into isoparaffins1 of substantially
1. It is a paraffin with branched chain molecules.

Vol. 4, No. 12 / Spring 2007 / 89
higher octane number.

The heaviest fractions (boiling range over 360°C) are distilled
again under vacuum to pro-duce vacuum distillate and vacuum
residue. The major portion of vacuum residue is fed to a visbreaker to
reduce the viscosity of the fuel oil products; this minimizes the
contribution of light distillate products, and the excess vacuum residue
is used as refinery fuel. The visbreaker is today the cheapest process
unit of fuel oil excess conversion into more valuable products.
However, a serious post-treatment is required - to meet the octane
numbers and sulfur contents - before blending the visbreaker’s outputs
into end-products.
The vacuum distillate is converted by a FCC to a gasoline
blending component and light cycle oil for blending into the diesel
pool. The FCC is today the most important process unit which is used
to increase the ratio of light to heavy products from crude oils by
operating at 500-550°C, and using a fluidised bed of zeolite catalyst.
This conversion unit also produces light olefines whose reaction with
iso-butane provides isoparaffins that constitutes a non-aromatic
gasoline blending component with high octane numbers. In our model,
the FCC is combined with an alkylation unit and operates following
8
two severities1 .
The other major unit in the model is the hydro-cracking process
which is simply defined as a combination of catalytic cracking and
hydrogenation reactions; this unit requires a dual-function catalyst and
a very high amount of hydrogen. As the reforming unit can not satisfy
alone the total requirement of hydrogen, a specific hydrogen
production plant (steam reforming) is also modeled.
Besides, the sulfur specifications for gasoline, middle and heavy
oil products requires the use of various hydrodesulfurization units
(HD, HX and HA). A Claus sulfur recovery processing is also
modeled to convert the H2S to liquid sulfur.
1. Severity is a way of defining the operating conditions, which can be more or less severe, of
a process unit.
90 / Vol. 4, No. 12 / Spring 2007

Figure 1. Typical refinery scheme
5-4. Petroleum products specifications

European and U.S. refineries are subject to environmental
specifications. Specially, gasoline and “on-road” diesel sulfur contents
were significantly reduced to 50 ppm in 2005 and will be set to 10
ppm by January 2009. In addition, the total aromatic content is
reduced from 42 vol% to 35 vol% in 2005. Since 2000, the olefins and
benzene contents have been limited to 18 vol% and 1 vol%
respectively. A review of European Union diesel specifications is
scheduled for 2006 (Houdek, 2005).
Between Europe and the rest of the world, trade of oil products can only take
place if the sulfur levels of petroleum products comply with the European
regulations. This point is of importance because most countries in Asia, Africa and
South America adopt sulfur specifications that set levels far above European
standards. For instance, the national specifications for sulfur levels in gasoline and
Vol. 4, No. 12 / Spring 2007 / 91

diesel in China are respectively 800 ppm and 2000 ppm, or 16 and 40 times higher
than European specifications. For our base case study (year 2005), we considered
the European specifications of the year 2005 for automotive fuels (Table 3).
Table 3. Specifications of gasoline and diesel in Europe

Quality Gasoline Diesel
Sulfur, max. (% m) 50 ppm 50 ppm
Cetane, min. (number) – 51
Poly Aromatics, max. (% vol.) – 11
Density – 845
RON, min. (point) 95 –
MON, min. (point) 85 –
Aromatics, max. (% vol.) 35 –
Olefins, max. (% vol.) 18 –
Oxygen, max. (% m) 2.7 –
Benzene, max. (% vol.) 1.0 –
Oxygen, max. (% wt.) 2.7 –
Source: Panorama IFP, 2005
6. Scenarios and simulations

6-1. Scenarios specifications
The objective of our simulations is to evaluate the impact of the sulfur
reduction policy on the marginal and average CO2 content of
automotive fuels at the gate of a European-type refinery. Three sulfur
specification scenarios based on 2005 (the base case), 2008 and 2010
have been defined (see Table 4). For simplicity purposes, we suppose
that there is no distinction between product specifications and the
actual levels required at the refinery gate to cover for possible
contamination in the distribution systems1.
Within these scenarios, oil products’ demand, crude oil supplies
and all other input and output prices (such as crudes and petroleum
products) are supposed to be the same as the base case. For the
medium term scenarios (2008 and 2010), only some realistic
investments could occur in the reforming and hydro-cracking units.
1. In order to guarantee a 10 ppm sulfur level at the pump, generally refineries aim at a level
of 6 or 7 ppm to take into account the pipeline contamination issues.
92 / Vol. 4, No. 12 / Spring 2007

Table 4. Sulfur scenarios for 2005, 2008 and 2010

Oil products Base case Scenario 2008 Scenario 2010
Gasoline 50 30 10
Diesel 50 30 10
Heating oil 2000 1000 1000
Unites: ppm
6-2. Marginal CO2 contributions of automotive fuels: a

prospective study
The results per automotive fuels featured in Table 5 correspond to the
marginal CO2 contribution of gasoline and diesel at the gate of the
refinery. They show that the gap between the marginal CO2
contribution of gasoline and diesel will be enlarged until 2010. This
important conclusion can be explained as follows. By 2005, European
refineries have already expanded the diesel fraction from oil refining
beyond its optimum balance with gasoline yield to meet the diesel-
oriented market demand. Technically, this imbalanced production
ratio has most probably resulted in higher production cost and energy
consumption for diesel, as compared to gasoline (for technical details,
see Kavalov and Peteves, 2004). Table 5 shows that, adding the ultra-
low sulfur specifications into the current imbalanced production
situation will further increase the marginal energy consumption and
the resultant CO2 emissions associated with diesel.
On the other hand, the marginal CO2 content associated with
gasoline continues to decrease and becomes even negative from 2008.
This unconventional result is mainly due to the catalytic reforming
unit, whose major function is to contribute to the gasoline blend but
also provides hydrogen as a by product. Meeting the ultra-low sulfur
diesel from 2008 would require to use more intensively the
hydrodesulfurisation and hydro-cracking units for which hydrogen is a
crucial input. For cost reasons, it happens that catalytic reforming unit
would operate at full capacity not in order to meet the gasoline
demand (which is decreasing in Europe) but to meet the increasing
hydrogen requirement of the refinery. This unusual situation would
inverse the major function of the reforming unit and would push
Vol. 4, No. 12 / Spring 2007 / 93
gasoline to become more and more as a “by-product” of this unit as

compared to hydrogen. Since the optimal solution of LP accounts for
all the interdependencies among process units, it does not wrongly
penalize the reforming unit for its intensive operation; and, therefore,
the gasoline pool receives a much lesser CO2 emissions than diesel.
The negative CO2 content of gasoline could confirm the “by-product”
nature of this product in European refineries in the near future. Note
that, however, the emission coefficients in Table 5 must be interpreted
with great care as they only correspond to the marginal production of
automotive fuels in the refinery. As far as the total CO2 emissions are
not fully allocated over oil products (because of the “non product”
active constraints), these marginal coefficients are only useful for
prospective WTT analysis. In other words, these marginal product-
related coefficients should not be compared with the results of the
accounting WTT studies in which gasoline production is in general
more energy-and CO2-intensive than diesel (e.g., IAE, 2005). An
optimal departure1 from the marginal CO2 content to average CO2
content associated with automotive fuels is the subject of the next
section.
Table 5. Evolution of the marginal CO2 contents

Gasoline 0.205 -2.483 -1.010
Diesel 0.357 0.690 0.800
Unites:tCO2/t
6.3 Average CO2 contributions of automotive fuels: a

retrospective study
Retrospective LP-based coefficients require the reassignment of the
process-related CO2 emissions over oil products. Following the
methodology presented in Section 4, we extract the MRTS
coefficients associated with the “non product” active constraints from
1. Here, an optimal departure means to preserve the cost efficient equilibrium of the refinery.
94 / Vol. 4, No. 12 / Spring 2007

the final simplex tableau, that is the optimal vector ϑi. . Table 7
summarizes these information in order to perform the first phase
calculations. Commercially available software for large scale models
include some especial commands to extract these coefficients. The
mathematical software we use is LAMPS (Linear And Mathematical
Programming System) and the available command is
TRANSFORMCOLUMNS (Advanced Mathematical Software Ltd.,
1991).
The quasi average CO2 contents α i (i ∈ M ) are calculated
according to relation (12) in Table 6. As it was expected, the relative
error term of the first step, є = θ l / ε , for the three simulations were
respectively 2%, 3% and 5%1 . We consider that these first-stage CO2
allocations are good estimations of the final average CO2 content
α iA (i ∈ M ) and the procedure can be successfully stop here.
Table 6. Evolution of the average CO2 contents
Gasoline 0.302 -1.189 -0.931
Diesel 0.567 0.752 1.503

Unites: tCO2 /t
The results per automotive fuels featured in Table 6 are now

comparable to those which are based on traditional accounting WTT
studies. Most of these latter overestimate the energy use and CO2
emissions of gasoline, as compared to diesel, due to the higher number
of gasoline processing units in European refineries. In our LP model,
the average CO2 content associated with automotive fuels are totally
in line with their respective marginal CO2 contents. That is, since the
equilibrium extent of gasoline-to-diesel conversion has been reached,
adjusting the a European-type refinery’s output to meet the new ultra-
low diesel demand, would be in average more energy-and CO2 -
intensive for diesel as compared to gasoline. Moreover, the gap
between diesel and gasoline average CO2 contribution would also be
1. The complete computations are available upon request from the first author.
Vol. 4, No. 12 / Spring 2007 / 95
widen further, because of the more expensive adjustment of diesel

properties to the new European standard requirements.
Table 7. Production elasticities associated with capacity and

calibrating constraints
Year 2005
DI RF IS IR PE HA HO BT JFimp. HA+HX
imp. imp.
Propane 0.00 -0.14 -0.04 -0.05 0.01 0.00 0.00 0.00 -0.03 -0.64
Butane 0.00 -0.05 -0.01 -0.01 0.01 0.00 0.00 0.00 -0.01 -0.43
Naphtha 0.00 -0.06 -0.02 -0.03 -0.06 0.00 -0.00 -0.01 0.01 0.41
Gasoline 0.00 0.01 0.01 0.01 0.01 0.00 0.00 0.00 -0.01 -0.12
Jet fuel 0.00 -0.11 0.01 0.01 0.01 0.00 0.00 0.00 0.01 -0.28
Diesel 0.00 -0.06 -0.01 -0.01 0.01 0.00 0.00 0.00 0.00 -0.15
Heating oil 0.00 -0.07 -0.02 -0.03 -0.04 0.00 0.00 -0.01 0.01 0.22
Heavy fuel 1%S 0.00 -0.57 -0.17 -0.26 -0.26 0.00 -0.02 -0.05 0.01 0.88
Heavy fuel -0.98 -0.30 -0.46 -0.73 0.00 -0.05 -0.13 0.01 0.97
0.00
3.5%S
Bitumen 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Year 2008 DI RF IS IR PE HA HO BT JFimp. HA+HX

imp. imp.
Propane -2.28 0.00 -0.10 0.00 -2.23 0.09 0.00 0.01 0.00 0.04
Butane -1.78 0.00 -0.08 0.00 -1.78 0.06 0.00 0.00 0.00 0.02
Naphtha 0.07 0.00 0.02 0.00 0.09 0.01 0.00 -0.01 0.00 0.07
Gasoline -0.63 0.00 -0.03 0.00 -0.65 0.02 0.00 0.00 2.40 0.00
Jet fuel 0.27 0.00 -0.01 0.00 0.09 0.04 0.00 0.00 0.00 0.18
Diesel -0.03 0.00 -0.01 0.00 -0.06 0.01 0.00 0.00 0.00 0.03
Heating oil -0.18 0.00 0.01 0.00 -0.15 0.02 0.00 -0.01 0.00 0.06
Heavy fuel 1%S -2.22 0.00 -0.01 0.00 -1.97 0.17 0.00 -0.03 0.01 0.38
Heavy fuel -1.00 0.00 0.18 0.00 -0.64 0.25 0.00 -0.09 0.01 0.86
3.5%S
Bitumen 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Year 2010 DI RF IS PE PE HA HO BT JFimp. HA+HX

imp. imp.
Propane 0.12 0.00 -0.26 0.00 -0.14 0.00 0.00 0.02 0.00 0.12
Butane 0.08 0.00 -0.29 0.00 -0.12 0.00 0.00 0.02 0.00 0.12
Naphtha -0.35 0.00 0.22 0.00 0.10 0.00 0.00 0.01 0.00 0.01
Gasoline 0.06 0.00 -0.15 0.00 -0.07 0.00 0.00 0.01 0.00 0.06
Jet fuel -1.16 0.00 -0.68 0.00 -0.52 0.00 0.00 0.14 0.00 0.47
Diesel -0.51 0.00 -0.27 0.00 -0.16 0.00 0.00 0.05 0.00 0.18
Heating oil -0.11 0.00 0.15 0.00 -0.04 0.00 0.00 0.01 0.00 0.02
Heavy fuel 1%S -0.65 0.00 0.85 0.00 -0.21 0.00 0.00 0.04 0.00 0.15
Heavy fuel -1.94 0.00 2.51 0.00 -0.32 0.00 0.00 0.09 0.00 0.28
3.5%S
Bitumen 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
DI = topping unit, RF = Reforming unit, IS = isomerization unit of type A IR = isomerization unit of type
B, PE = FCC feed Pretreatment, BT prod. = Bitumen production HA = revamp of the desulfurisation unit,
HO imp. = Heating oil importation JF = Jet fuel importation, HA + HX = Total capacity of
desulfurisation units.
96 / Vol. 4, No. 12 / Spring 2007

7. Conclusion
In this paper we distinguished between prospective (marginal) and
retrospective (accounting) WTT analysis. We argued that prospective
analysis should be considered when the objective is to explore the
environmental effects associated with the marginal production of a
given automotive fuel. On the other hand, retrospective analysis is of
interest when the main objective is to evaluate the average
environmental impacts of a given automotive fuel in transportation
studies. It was also explained that, an exact prospective/retrospective
study for the production of automotive fuels requires to assess the
marginal/average contribution of gasoline and diesel to the total CO2
emissions generated within the refinery. Oil refining is one of the most
complex joint production system, and traditional WTT methods fail to
account for the complete interaction and substitution effects among
the process units.
In order to compute the marginal/average contribution of
automotive fuels at the gate of refineries, a practical method based on
linear programming was developed. We illustrated that the
marginal/average LP-based emission coefficients which emerge from
the optimal solution, as opposed to the ones computed by traditional
methods, include all consequences of the desired change on the
operation of the refinery as well as compositional changes of the oil
products. In other words, these emission coefficients embody the
physical and process relationships in the refinery system and provide a
more realistic estimates of the environ-mental impacts of automotive
fuels.
Using the LP model developed in Sections 3 and 4, we
estimated the marginal/average CO2 contribution of the petroleum
products for a typical European refinery. Then, three simulations for
years 2005, 2008 and 2010 were performed to evaluate the impact of
the sulfur reduction policy on the CO2 content of automotive fuels at
the gate of the refinery. Based on the obtained numerical results, the
following core conclusions can be highlighted. Due to the transport
and fiscal policies in most of the European countries, the demand for
automotive diesel, at the expense of gasoline, has been drastically
Vol. 4, No. 12 / Spring 2007 / 97
increased from the past 10 years. Since the equilibrium extent of

gasoline-to-diesel conversion has been reached, adjusting the
European refineries output to meet the new oil product quantities,
would be more energy-and CO2 -intensive for diesel. Moreover, our
estimates follow the general conclusions driven by Kavalov and
Peteves (2004) who claimed that the gap between diesel and gasoline
CO2 contribution would be widen further, because of the more
expensive adjustment of diesel properties to the new European
standard requirements.
A surprising result was the negative marginal/average CO2
contribution of gasoline at the gate of the refinery from 2008. This
fact, however, could be perfectly explained by the continuously
declining demand of gasoline, on the one hand and, on the other hand
by the increasing hydrogen requirement in the refineries due to the
new quality specifications. This imbalanced situation would inverse
the major function of the catalytic reforming unit and, would cause
gasoline to become more and more as a “by-product” of this unit and
the whole refining system. Hence, the negative CO2 content of
gasoline should be interpreted rather as a confirmation of the “by-
product” nature of this oil product in Europe in the near future.
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100 / Vol. 4, No. 12 / Spring 2007

Age Estimation of Car Fleet and its

Impact on Fuel Consumption in
Iran:
Efficiency vis-à-vis Renovation
Mohammad Mazraati1
Abstract
Volume of gasoline consumed in Iran is determined by such different
factors as gasoline price as well as efficiency, age, and number of cars
in use among many other structural and cultural variables. This paper
considers the average age and efficiency of cars and gasoline demand
models as a function of the age, efficiency, price and other
explanatory variables to prove that although renovation of the fleet
could have positive impact on fuel saving, it is yet to be the most
effective approach. It also shows that mandatory efficiency standards
for car manufactures and imported cars like the CAFÉ standards in
US, could lead to improved efficiency of car fleet, where lower cost
within a shorter period of time are incurred. The short term efficiency
elasticity of gasoline demand is -3.5 which proves the above
mentioned hypothesis. One percent increase in the efficiency of the
fleet would lead to about 3.5 percent decrease in gasoline demand in
the short run denoting a considerable fuel saving. The short term price
1. Energy Models Analyst, OPEC secretariat, Vienna, Austria, mo_mazraati@yahoo.com and

mmazraati@opec.org
Vol. 4, No. 12 / Spring 2007 / 101
elasticity of gasoline demand is estimated at -0.17 demonstrating

insignificant response of demand to price in short term although a
higher impact can be envisaged in long term. The car age and
elasticity of gasoline demand by the fleet of cars are estimated at 0.16
and 0.43 respectively. The elasticity of the number of cars is less than
unit but it is still considerable and indicates the considerable impacts
of growing size of the fleet on fuel demand. The current development
of the fleet size is indicative of a dramatic rise in the number of
registered cars which in turn translates to sharp increase in gasoline
demand in the future. The paper concludes that in order to get better
results, such measures as rationalizing gasoline prices, decreasing
average lifetime of car fleet, enforcing the CAFÉ standards to improve
the efficiency of cars, levying higher taxes on old cars, scrapping
down the old vehicles among other policies should be considered as a
part of general policy.
Keywords: average age of car fleet, Iran, Café standards, fuel

efficiency, renovation of car fleet, scrappage, transportation,
gasoline consumption
102 / Vol. 4, No. 12 / Spring 2007

Impacts of Oil Price

Shocks on Economic Variables
in a VAR Model
A. Sarzaeem 1
Abstract
In recent decades, volatility of oil prices has led to such consequences
as macroeconomic turbulences. Most of the researches look at the
matter from oil importer's point of view while oil producers are
usually neglected. This paper explains the relationship between oil
price shocks and economic growth and inflation by the econometric
methods like VAR model and OLS regression. Based on quarterly
data, an unrestricted autoregressive model is estimated in order to
gauge short run effects of oil shocks on different variables such as
exchange rate, money, government expenditure, inflation and GDP.
Long run effects are also measured by the aid of a co-integration
autoregressive model. Impulse-response technique is used to estimate
reaction of aforementioned variables to different shocks. At the end,
the paper proposes the economic policies based on statistical results.
Keywords: Oil price shocks, VAR model, macro economics.
1. Expert, Institute for International Energy Studies (IIES), alisarzaeem@gmail.com

Vol. 4, No. 12 / Spring 2007 / 103
Recent Crude Oil Market

Developments:
Making Structural Models
Mehrzad Zamani1
Abstract
The recent oil market conditions, have confronted analysts with
serious challenges in their efforts to analyze oil price trends and the
reasons behind them. They have, so far, addressed the issue on the
basis of structural changes, periodical behavior and speculation. The
roots of those challenges, in their view, are embedded in the
influential development of fundamental elements on the price of oil.
OPEC's oil production in the 1990s, is a case in point, which
materialized the organization's price objectives very effectively. The
organization, however, has lost its price controlling mechanisms and
capabilities in recent years. The relationship of crude oil prices and
commercial stockpilings has also reversed. This study reviews
changes in the fundamental factors on the basis of econometric
models. According to results, OPEC's excess or surplus production
capacity in recent years (post 2003) has affected the relationship of oil
stockpilings and prices. OPEC's surplus production capacity had no
impact on oil prices prior to 2003, when it began to demonstrate its
influence. Thus, OPEC which set its members' production quotas in
1. Expert, Modeling and Long term energy studies Group, IIES, E-mail: m-zamani@iies.net
104 / Vol. 4, No. 12 / Spring 2007

light of stockpiling levels, in its pursuit of price objectives, is

presently influencing the oil market with its excess capacity.
Therefore, through its quota setting mechanism, OPEC is facing two
opposing effects of the changing stock-levels and the surplus capacity,
and currently the role of the second is superior.
Key words: Oil price, Oil market fundamentals, OPEC. Reversing

factors
Vol. 4, No. 12 / Spring 2007 / 105

A Survey of New Structure of

LNG and Natural Gas Industry in
the World
Eshagh Mansour kiaee1
Abstract
Hegelian process of change dictates that when entity (thesis) is
transformed into its opposite (antithesis), the combination would be
resolved in a higher form (Synthesis). It seems that global liquefied
natural gas industry is undergoing such a process. The process of
restructuring traditional monopoly in LNG industry materialized by
market liberalization and privatization requires a new form of
structure that benefits from competitive markets. This paper discusses
the probable impacts of liberalization on the future developments of
LNG industry. The paper also examines the probability that whether
Hegel's invisible hand would be able to transform the traditional
monopoly in LNG industry into the restructured one involving viable
competitive markets.
Key terms: Hegel's Dialectic Theory, LNG, Traditional Model of

Natural Gas Trade, Competitive Markets Model, Liberalization,
Prices, long-term contracts, spot market.
1. National Iranian Gas Export Company (NIGEC), LNG marketing expert ,

m.kiaee@nigec.com
106 / Vol. 4, No. 12 / Spring 2007

IIES Quarterly Energy Economics Review Vol 4 No 12 SP 2007

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IIES Quarterly Energy Economics Review Vol 4 No 12 SP 2007

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Quarterly

Energy Economics Review

Proprietor: Institute for International Energy Studies

Editoral Board: Hamid Abrishami(Ph.D.)/ Tehran University,

INSTITUTE FOR INTERNATIONAL ENERGY STUDIES

Vol. 4, No. 12 / Spring 2007 / 1

1. Econometrician, PMAD Department, Research Division, OPEC Secretariat, masali@opec.org

2 / Vol. 4, No. 12 / Spring 2007

Key terms: Petroleum market, dynamics, OECD, VAR model,

Vol. 4, No. 12 / Spring 2007 / 3

4 / Vol. 4, No. 12 / Spring 2007

OIL Consumption OECD

Economic theory suggests existence of equilibrium relationship

demand and inventory have appeared to move independently of each

have needed to formulate explanatory equations for each of these

2. A monthly oil market VAR model for OECD

Vol. 4, No. 12 / Spring 2007 / 7

2.1 Time series properties of the VAR model variables

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comprehension of the VAR system of concern. Using 12 years of

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properties as a first check of the assumptions of the VAR model.

........................................D...............Y .............P ∗ ...............S ...............∆D...............∆Y ..........

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If in rare cases we found answers to both questions negative, it

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idea to find out whether the outlier observations can be related to

Fig. 3 Differences of the Model's Time-series

As was mentioned before, there seem to be some outlier

Vol. 4, No. 12 / Spring 2007 / 13

1-Month Difference (WTI)

12-Month Differenc (WTI)

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As was mentioned before, there seem to be some outlier

Fig. 4. The graphs of the residuals from the VAR model

LRWTI Residuals LTSOECD Residuals

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Fig. 5 Histograms and Autocorrelation Functions of the Series

Histogram Kernel Normal

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Fig. 6. Histograms and Autocorrelation of the First Differences

Histogram Kernel Normal

Actual Theoretical Actual Theoretical

Actual Theoretical Actual Theoretical

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18 / Vol. 4, No. 12 / Spring 2007

RESIDUALS LRWTI RESIDUALS LTSOECD

Histogram Kernel Normal

In Figure below, the histograms and auto-correlograms are

Correlogram Residual LDOECD Correlogram Residual LIPIOECD

Correlogram Residual LRWTI Correlogram Residual LTSOECD

To understand the implication of auto correlation for residual plots

20 / Vol. 4, No. 12 / Spring 2007

2.2 The statistical adequacy of the model

Where X is a vector of variables, i.e. X=[D, Y, P, S] and Π is a

And the deviation of Xt defines ε t as:

hypothesis on the assumptions needed to justify the VAR (see:

2.3 A Tentatively unrestricted VAR (2)

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− 0.02........0.03... − 0.4 ∗.... − 0.67   D1− 2  ε 1,t 

0.02......... − 0.01.......0.05......0.45   S t − 2  ε 3,t 

Statistics.. for.individual.. var iables.......D.................P...............S .............Y