Case of the Day: Oil-Price Dynamics
Oil prices are among the most volatile and closely watched prices in the global economy. Large price changes in the market for oil futures are often reported in news headlines, along with speculations about demand and supply factors that may have caused the changes.
The staff of the Federal Reserve Bank of New York publish a weekly Oil Price Dynamics Report that performs a quantitative analysis of the effects of supply and demand on this week's oil price. In this case, you will examine the evidence for the 2020 pandemic period, during which oil prices have fluctuated widely, and the broader trends following the global financial crisis of 2008-09.
During March 2020, the oil market was blasted with two large shocks: (1) a political row between major producers Saudi Arabia and Russia leading to raised production and (2) a reduction in demand due to decreased fuel use as coronavirus shut-downs kept people at home. Either could cause prices to fall and, indeed, prices fell dramatically and quickly. But what was the relative importance of the two factors? This is what the FRBNY analysis attempts to disentangle.
Using the link above, download the most recent report. This provides very current information presented in two main graphs. The line graph goes back about 3 months and decomposes changes in the Brent crude price into the effects of demand factors, supply factors, and a residual. (The residual is the change in price that cannot be predicted by the factors that they use to model supply and demand.) The area graph below goes back ten years and shows the cumulative effects of demand, supply, and the residual over a longer period. (The line within this graph is the actual price, which is the sum of the three components.) In both graphs, changes are expressed as changes from the initial date in log terms. For small changes, the change in the log of price is approximately equal to the percentage change in price, though this breaks down once the log-change gets above 10-20% or so. A negative value means a change in supply or demand that would lower price (an increase in supply or a fall in demand). The price that is tracked in this analysis is a futures price for delivery very soon of Brent (North Sea) crude oil.
At the very bottom of the site, there is a button labeled "Archives." Click on this button to open links to past reports and download any that you think might be helpful.
Questions
- In words, how would the economists at the Fed go about performing this analysis? What factors would they use to estimate demand effects? Supply effects? Why is there a residual and what does it measure?
- What does their analysis say about the relative importance of shifts in demand and supply during early 2020? From 2010 to 2020? (Their analysis is mostly graphs and light on words. You are to add the words.)
- The Fed's analysis is based on the price of Brent (North Sea) crude. The other main traded oil-futures contract is West Texas Intermediate (WTI) in the United States. Why would these prices tend to be similar? Why are they not always the same?
- In April 2020, the market price of WTI near-term futures contracts actually briefly fell to negative $40! What does this mean and how could it happen?