Understanding crude oil prices

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

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

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

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

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