HOW MUCH OF THE OIL DECLINE CAN BE ATTRIBUTED TO GLOBAL DEMAND FACTORS?

Recently, Ben Bernanke wrote a blog post that attempted to quantify how much of the oil decline can be attributed to global demand factors. The model builds upon the work of James Hamilton who estimated a regression where changes in oil are determined by changes in copper prices, the 10-year treasury yield, and the dollar. Comparing the predicted and actual decline in oil prices, Ben Bernanke finds that something in the range of 40-45 percent of the actual decline in oil prices since June 2014 can be attributed to unexpectedly weak demand. DavidBeckworth, former economist at the U.S. Department of Treasury, also wrote a blog post where he reestimated the model, but added the BAA minus the 10-year treasury spread as another indicator of global demand conditions. Using his specification of the model, he was able to attribute 51 percent of actual decline in oil prices to unexpectedly weak global demand. Bernanke used daily data since mid-2011, while Beckworth since January 2007.

Here I’m going to tackle the same question.  How much of the oil decline can be attributed to global demand factors? I’m tired of hearing that the most important factor has been surging U.S. oil production. But I’m going to do so in the most elegant way I can think of within the same framework. So I’m going to use only copper prices and the 365 day lagged spread between the copper and oil price. I used daily data since 31 January of 2000. Using my model which includes an error correction term, I’m able to attribute 64 percent of the actual oil decline (49.4%) since June 2014 to December 2014 to global demand shocks. This is, even if we knew nothing on the production side of the oil market, we would have anticipated the price of oil to have fallen 32% in December 2014 since June 2014 given unexpectedly weak global demand and past deviations of the spread between the oil and copper price from equilibrium. In relation to the actual oil accumulated decline (64.8%) in December 2015 since June 2014, 54 percent is due to systematic shocks (as opposed to oil supply shock) according to the model.

I resuscitate Engle and Granger (1987) to tackle this question. My approach is based on the fact that the oil and copper price are cointegrated, so past deviations from equilibrium of the spread between them influence today’s oil and copper behavior. So there is useful information in the past spread that we should use to predict present oil change. It makes no sense knowing that the oil and copper share an equilibrium relationship so they tend to make up for past deviations from equilibrium and not incorporating past deviations from equilibrium to form expectations on oil changes.

The procedure is the following: First I estimated the cointegrating equation using data since 31 January of 2000 to June 2014. 

Then I used the residuals from this regression as an explanatory variable in the equation for the 365 day oil percentage change. So in the second stage, I regressed the 365 day oil percentage change on the 365 day copper percentage change and 365 day lagged spread between the copper and oil price (residuals from the first equation), using data since late June 2001 to June 2014.

e.c2

Finally, I used the coefficients from that equation to see how much of the drop in oil prices since June 2014 we would have expected to observe, given the observed drop in copper prices and past deviation of the spread from equilibrium. Only the fraction of the observed declined in oil price that can’t be explained by this model, may be attributed to supply oil shocks. On average, I was able to attribute 60 percent of the actual accumulated decline in oil prices during 2015 since June 2014 to unexpectedly weak global demand . As you can see, there is no evidence that the most important factor explaining the oil fall has been surging oil production. Supposed, right now I’m standing in June 2014 and Marty Mcfly (just someone from the future) reveals to me ONLY the copper price time series, an indicator of global nominal spending conditions, since July 2014 to December 2015; the dotted red line in the following graph represent the expected  path for the oil price I’m able to come up. Now supposed an alternative future where the oil price in Dec.2014 declined only by 20% since June 2014. Now you see that it makes no sense to argue that the oil decline was due to a positve oil  supply shock, since I was expecting it to fall further (by 32%).

Author’s calculations based on ec.2
Data downloaded from Bloomberg.

THE OIL CRASH AND FED POLICY

UPDATE: 

1. I’m glad to announce that this post was cited here by David Beckworth, former economist at the U.S. Department of Treasury, who recently wrote an amazing post in the New York Times discussing the role of fed monetary policy in the great recession of 2008-2009.

2. You should read this post first, which is the subsequent one (I know that’s weird). In that post I showed that the oil’s decline since June 2014 is mostly due to global demand shocks as opposed to positive oil supply shocks. So now we should ask what caused global demand indicators to deteriorate more than expected since mid-2014. Thas what I do in this post.

Currently, discussions in the financial world revolve around the fall in oil prices; it has dropped roughly 70% since June 2014. What are the causes, everyone is wondering. It is said that the fall is due to the economic slowdown in China, together with an increase in oil supply. In fact, some argue the economic slowdown in China alone explains the phenomenon. This is a fairly weak hypothesis because output growth rates in China during 2014 were in line with trend observed over the years 2006-2013. That is, analysts were not especially surprised by low growth rates in China recorded during 2014 (analysts were expecting a slowdown anyway). Note that prices moves in response to shocks (news/surprises) or changes in expectations. I’m arguing that the actual 2014 output growth rates in China were not that far form expected as to imply the huge fall in oil nor analysts suddenly became pretty pessimistic on the economic outlook for China just in the middle of 2014. The second hypothesis that attributes the drop in oil prices to a positive oil supply shock is also inadequate since not only oil began to decline in middle 2014, so did copper. In fact, in general, commodity prices also start declining around that date.

NORMALIZED PRICES: JANUARY 2012=1. WTI PRICE: RIGTH AXIS

Therefore, for that hypothesis to makes sense, we would have to argue that the positive oil supply shock (something idiosyncratic to that market) somehow caused the decline in commodity prices. I understand that there is maybe nonlinearity in the effects of oil fluctuations as Krugman noted. This is, a “small” drop may be nice for the economy but a “huge” one may well send the world economy to hell. So it’s possible that a positive oil supply shock may cause a decline in commodity prices through its negative effect on world spending. But this is not the case because right after the oil started plunging (before it had dropped 70%) we saw a slowdown in the stock market and an increase in the rate spread on corporate BBB bonds (meaning higher default risk and/or risk premium which signal a negative nominal spending shock) and the market were not expecting at all the oil would fall 70% in coming months.

MID 2014: THE STOCK MARKET STARTS TO SLOW DOWN AND RATE SPREAD INCREASE

Moreover, the crude oil stock do not showed an increase during 2014, but did so during 2015 as a consequence of, you will figure that out later.

So what explains the drop in oil prices, moreover, in commodity prices? Well, something unexpected (a change in expectations) happened somewhere in middle 2014. What happened?

Short story: it was a (contractionary) monetary shock stemming from the Fed; markets expectations on the 12 months ahead short rate (fed funds rate) (changed) began to rise from mid-2014. So the fed started to tighten. Naturally, the nominal dollar began to appreciate multilaterally, which, given the current configuration of macroeconomic policies in China, meant a negative impact on the expected growth of nominal spending in China.

FINALLY, THE CHANGE IN EXPECTATIONS  I WAS LOOKING FOR

China imported the tight Fed monetary policy; its currency also appreciated against the world, because China has its currency pegged to the dollar and holds large amounts of foreign reserves which give credibility to the peg, at a time when it needed just the opposite given the necessary economic slowdown that was already in progress. China is just too big by itself, let alone its influence on emerging markets; therefore, the negative impact on the expected growth of nominal spending in China (due to the appreciation of the renminbi multilaterally) implies a decline in global prices, including commodity prices (oil, cooper, etc.). Of course, its international reserves had to decrease as Mundell-Fleming would have expected (because of its fixed exchange rate, capital were leaving the country and was expected to cut its short term interest rate!)

WHAT A WASTE, THEY WILL HAVE TO DEVALUE IF THE FED CONTINUES WITH ITS "NORMALIZATION" PROGRAMME

You can’t understand the oil crash without understanding the link between Fed monetary policy and actual /expected nominal spending in China. In other words, you need Mundell-Fleming framework and had recognized the key role of China expected nominal spending in oil/commodity prices fluctuations.

So we don’t really need an increase in expectations on real GDP growth in China or elsewhere or oil producers cutting back production to see a rebound in oil prices. We only need a change in market expectations about future Fed monetary policy.

I think it’s unlikely the Fed is going to recognize explicitly its role on the oil crash but I do think is going to backpedal or invade, wait whaat (getting bored) persuade china to abandond the peg (by now it should be clear that the Fed don’t need to actually change its rate, right?) And when that happens, the oil will rebound. Of course, break-even inflation rates and the stock market will rise too.

PS. There is a common/global risk factor in oil and copper prices. It’s monetary in nature, it’s the Fed! This applies also to, well, almost every risky asset there is.