1. Undergraduate Report
Faisal M. Hamawi
Research Methods in Economics
12/02/2016
The Effects of Changes in Oil Supply on the Price of Crude Oil
1. Introduction
Oil price shocks may present significant concerns for economists, but the source of
such price shocks are stochastic (Hamilton 2008). Oil price shocks could sometimes be
attributed to demand shocks such as changes in aggregate incomes of large importers or
speculation by buyers. Some shocks are attributed to supply shifts such as catastrophes
involving oil production, advancements in extraction technologies, expectations of suppliers,
output freezes, and alternate source of energy. Finding the driving factors of oil shocks and
determining just how much they affect global economies can be beneficial for economists,
politicians, and analysts in forecasting future activities in economic markets. Having some
insight allows us to leverage our opportunities, so fluctuations in prices do not adversely and
significantly affect the business cycle.
The goal of this paper is to find evidence of correlation and causation between oil
prices and various economic variables in the commodity market for oil, through analysing
existing research on the subject and examining historical data. Whether oil supply shocks
such as the changes in the production of oil, inventory levels and above-ground stock, market
share of producers, extractability, and a demand variable of national income statistically
influence the price of crude oil for both the New York Mercantile Exchange (NYMEX) WTI

2. oil, and Brent oil. This question of interest presents great potential in predicting future oil
price movements given the events that may unfold in the world around us.
2. Literary Review
Oil production and Oil Prices:
Oil supply shocks may have little to do with the quantity supplied of oil, since their
exhibited implications in the past contribute to only a small fraction of observed oil prices.
(Kilian 2006) In the period between 1973-1974, the Arab Oil Embargo led to a hike in oil
prices from the previous low of about $20 per barrel to about $50 a barrel. The Iranian
Revolution of 1978 to 1979 led to a hike in oil prices to the highest price level it's ever been
in that nominal period, from a low of about $52 to a high of about $114. All these exogenous
events led to drops or freezes in oil production, driving prices up. In the year 1990 world
output declined significantly, reaching record lows not experienced in decades, resulting in
upwards pressure on prices. (Kilian 2007) (​Krichene 2002​). Any supply shock by a large
player in the oil market may contribute to a major stagnation in world oil production, which
could drive prices up regardless of the time period. (Liu, Wang, Wu, Wu 2016) An observed
stagnation of about 75 million barrels of oil per day by oil producers in the period between
2005 and 2008, led to an upturn in oil prices from about $55 a barrel to about $151 nominally
in the peak of the 2008 recession. (Liu, Wang, Wu, Wu 2016) These declines of oil
production by Middle Eastern countries and the conflicts revolving their oil production and
supply provide ample evidence of this supply price relationship, though only proving to be
temporary.
Prices had reached their highest levels ever in the real periods between 1973-1985, to
where global oil producers had to stabilize production and maintain a steady price level
throughout that period. (Krichene 2002) Relatively speaking, oil production fluctuations are
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3. not totally responsible for the price hikes within those decades. Many other factors may have
contributed to such oil price shocks. Some of which may involve demand side speculation,
where consumers would witness such events affecting the oil producing countries and react in
ways that would exaggerate the price. (Hamilton 2000) However, speculation is a demand
shifting variable and is irrelevant to my analysis.
Market Share of Oil Production:
In the short-run, disruptions in the oil supply may cause drastic changes in the price of
crude oil, as the market is unable to respond fast enough. (Greene 2010) In the long-run,
supply cuts by OPEC countries will not maintain high oil prices, since the market share of oil
production will adjust. Non-OPEC countries will adapt to the high prices in the long-run by
either producing and exporting their own oil (increasing the market supply of oil), or
including other Non-OPEC oil producing countries to produce more crude oil. This causes
fluctuations in the market share of the oil market. (Greene, 2010) In 1979 Saudi Arabia and
OPEC members abandoned their high price defensive strategy, and sacrificed significant
market power and market share. In the 11 years between 1974 and 1985, OPEC had lost
about 25.5% of their market share, while the commodities prices returned to their initial price
of about $50 a barrel. (Greene, 2010) Some believe market share is a driving factor of oil
prices, though some may add that market share is determined by how well OPEC meets the
quotas of production set by themselves. (Kaufmann 2004)(Campbell, Laherrère 1998) It is
believed that OPEC can maintain market share indefinitely if they consistently meet their
quotas. Since they often do not, market share and prices fluctuate. the assumption states that
if OPEC meets their quota, the oil market is in equilibrium and price volatility is low. Since
this is not always the case, the assumption examines the extent production differs from their
set quota. If OPEC fails to meet their quota, production fluctuates, market share changes due
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4. to Non-OPEC production shocks, and prices become more volatile since OPEC derives their
quotas to match the difference between oil demand and non-OPEC supply. (Kaufmann, Dees,
Karadeloglou, & Sanchez, 2004) Another idea add a few more points to this argument in their
analysis where market share is examined but in an Oligopolistic scope where only two
players exist, OPEC and Non-OPEC countries. They believe, considering OPECs current
share in the market, that Non-OPEC countries are price takers and OPEC has the dominant
hand in setting world prices of oil. With the help of a Jones Cliftons research, (1990) that
OPEC countries, especially Saudi Arabia, did manipulate falling prices by adjusting outputs
to maintain their price incentives. However, they observed that from the period of 1970 to
2004 OPEC had lost a significant share of market power and to treat OPEC as a dominant
firm would be inappropriate. (Ghassan, Banerjee 2014)
The quantity of oil supplied is a fundamental factor of real oil prices. The market
share held by oil producers play large roles in determining prices, but I must still account for
other supply variables such as reserves or inventory levels, and scarcity.
Oil Reserves and Inventories:
Oil reserves and above-ground stock play large roles in the fundamentals of supply
that affect crude oil prices in the commodity spot and futures market, where it is observed
that there is an inverse relationship between the price of oil and crude oil inventory. Increases
in inventory levels in the United States led to distortions in commodity prices in the U.S.
crude oil market. (Singleton 2012) A strong negative (inverse) relationship between the net of
strategic petroleum reserves (SPR) and prices of oil in 2003 is evident in that period
(Singleton 2012). However, these observations are not consistent from period to period since
the prices are determined through the global commodity market and is not exclusive to the
United states.
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5. Holding inventory of a commodity creates a smoothing effect when an increase in
uncertainty occurs, where a large stock of a commodity, such as oil, will buffer a supply
shock that may occur in the future as a result of an embargo or catastrophe. It is argued that in
the midst of the speculative activities of the commodity market, comovement between the
inventory levels of strategic petroleum reserves and the prices of crude oil can be found. A
fundamental shock in the oil market may lead rational players to increase inventory holdings
by bidding up prices. (Pirrong 2008) This comovement in oil prices and inventory can be
seen in the periods between 2005 and 2006. Speculation may be the reason for such an
anomaly, arguably. It is believes the speculative nature of the industry is what drives prices,
through the direct actions of Players regarding their inventory levels. (Pirrong 2008) If a large
player relaxes inventory, speculation regarding the oil market is reduced which leads to a
decline in the prices of crude oil in the tradable spot and futures market. However, this
stochastic relationship between inventory levels and crude oil prices fluctuate constantly,
from positively to negatively correlated. Arguing a similar idea, as speculators in the
commodity market expect future shortfalls in oil supply by exogenous global events, demand
for above ground inventory would increase, causing the real prices of oil to increase.
However, the main difference in this argument is that uncertainty shocks would not be
associated with expected changes in real oil production, storage, and economic activities.
(Killian, Murphy 2013)
Capability of Extraction:
Crude oil is a non-renewable resource with limited extraction capabilities. Though
crude oil is abundant in nature, the amount of extractable oil is becoming more scarce over
time as producers begin tapping their wells. So as the threat of “running out of oil”
increases, the price of crude oil is expected to increase as a non-renewable, limited resource.
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6. Innovators will begin making alternate and renewable sources of energy more efficient and
affordable as to one day replace fossil fuels (Sims, Rogner, Gregory 2003). This threat of
substitution may only prove to be more prominent in the future. It is estimated that the
average decline rate for all producing fields reaches 4.07% annually over the period 2010 to
2015. (Owen, Inderwildi, King 2010) It is estimated that since 1985 liquid fuel consumption
has grown at an average annual rate of 1.42% and will maintain an increasing rate. That by
the year 2030, the world will consume 42.5 Gb per year. (Owen, Inderwildi, King 2010) This
figure of consumption is unsustainable, where through data maintained by the Energy
Information Administration (EIA), that the demand will not be met. Since actively producing
oil fields, developing oil field, and oil field yet to be found level off or even decline in the
near future. Their argument assumes that in the future the price of oil may climb to extremely
high levels as a result of aging wells. By the year 2030, the price of oil would reach $200 a
barrel. (Owen, Inderwildi, King 2010) It is also argued that though the scarcity rent of oil
supply may have been negligible in the past, it will now and further into the future become
more significant. (Hamilton 2008) Though this may be the case, oil producers and exporters
are wise enough not to deplete their resources and cause a shift in energy demand. Such shift
would cause fluctuations in price volatility that could jeopardize economic markets, but could
potentially be avoidable if approached accordingly. (Hamilton 2008)
Income:
Treating GDP per capita as an exogenous variable, I can begin to compare economic
conditions in the United States to the demand for crude oil. GDP per capita is a measure of
total output per person for a given country. It is one of the primary indicators of a country's
economic performance. In the Fundamentals of Macroeconomics, if GDP growth increases, it
is expected that wages and salaries will also increase, and so will consumption demand.
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7. (Edmund Phelps) Private enterprises are more profitable as a result, leading to increases in
investment spending, and consumption of fixed capital. (Edmund Phelps) In examining the
effect of the business cycle/economic activity on the price of oil, one researcher focused on
the demand of oil and its impact on the freight of crude, where freight is a direct measure of
economic activity. (Kilian 2006) If a given economy was at full employment and demand for
crude oil is high, empirical analysis would indicate increased freight traffic. Given the excess
capacity of freighters of crude oil due to an upswing in economic activity, we would observe
a perfectly inelastic long run supply curve (vertical supply curve). (Kilian 2006) So any shift
in demand due to economic activity could directly impact price, and any shift in the supply of
oil could inversely impact prices in the long-run.
Conversely, in observing the periods of 1978-1981, as U.S. real GDP increased, oil
consumption had decreased contrary to expectation. Noting that “one would expect oil
consumption to have risen, rather than declined.” (Hamilton 2008) This phenomena is
attributed to an inelastic price and income elasticity of that period. Assuming unit elasticity, I
would expect oil consumption to increase at the same rate as GDP growth. And as observed
with an income elasticity of 1.2, oil consumption grew faster than GDP in that same period.
(Hamilton 2008) After looking at the data for the periods of 1985-1997 one would see
dramatic adjustments in price and income elasticity, where oil use grew at a rate about half of
what GDP had grown despite declines in real oil prices. (Hamilton 2008) This suggests that
income elasticity of U.S. petroleum demand fluctuates significantly from period to period,
which may or may not cause prices of oil to change as GDP per capita grows.
3. Analysis
The impact of the many exogenous variables in question on the price of crude oil is
important for various reasons, it allows us to anticipate and predict fluctuations in prices.
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8. Though it may be difficult to estimate, considering the volatile and stochastic nature of the
commodity, knowledge of how oil prices may react to different conditions may give us some
insight into the future. Though nothing is certain, my question is, “how do changes in the
supply of crude oil affect the price of oil per barrel?” I will also examine various other supply
variables in a multivariate model.
I will be using an Ordinary Least Square estimator to conduct a regression analysis, to
best explain movements in price after accounting for statistical significance, assuming all
OLS conditions hold. The economic model I have developed is:
, where(A , , , , , , , )Pt
A
= F t
US
Bt
OPEC A
Ct
B
Ct
DUS
spr DUS
exc Rt Y t (A , , , , , , , )Pt
B
= F t
US
Bt
OPEC A
Ct
B
Ct
DUS
spr DUS
exc Rt Y t
is the price per barrel of oil identified by the New York Mercantile Exchange IndexPt
A
(NYMEX) WTI which is mainly sourced and traded in the United States. is the price perPt
B
barrel of oil identified by the Brent crude oil index (Brent) traded under the ICE Futures
Europe. Crude oil prices are identified as a function of Production, is the U.S. total oilAt
US
produced per quarter, and total oil produced by OPEC per quarter, I will be taking theBt
OPEC
natural log of these variable to measure the percent change in production. Market share,
where is the fraction of market share the US holds in a given quarter, and is the fractionA
Ct
B
Ct
of market share OPEC holds in a given quarter. Inventory, where is inventory of crudeDUS
spr
oil held by the U.S. categorized as Strategic Petroleum Reserves (SPR), and is theDUS
exc
inventory of crude oil held by the U.S. that excludes SPR, these variable will be in
logarithmic formate as to measure percent change. is the number of active oil rigs in theRt
U.S. extracting crude oil, and is U.S. GDP per capita in a given quarter, where I willY t
measure the percent change quarter to quarter of nominal GDP per capita.
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9. I will be examining quarterly data from the first quarter of 1990 to the third quarter of
2016. I will also be assuming all these variables as exogenous variables, though some may
contain endogenous properties and relationships. To specify my Population Regression
Function, where+ + D + D + R + YPt
A,B
= β0 + β A + B +1 t
US
β2 t
OPEC
β3
A
Ct
β4
B
Ct
β5
US
spr β6
US
exc β7 t β8 t + Ut Ut
is my disturbance term of the population. Upon utilizing an Ordinary Least Square estimator,
given the sample of the population I’ve gathered, (Q1 1990- Q3 2016) I expect to minimize
the sum of the square errors, as to maintain zero conditional mean assumption of
unbiasedness. (the values of X are independent of U, and the expected value of U is zero) I
will also test for heteroscedasticity to maintain efficiency, (Variation in X is independent of
U and constant), where I will reject the null hypothesis of homoscedasticity at the 1% level of
significance for both Regressions (NYMEX and Brent significance levels of were 28.12hiC 2
and 28.74 respectively), and I will correct for heteroscedasticity by creating a robust estimate.
Oil Production:
In the periods between 1990 and 2016, the average U.S. market share of production
was about 8.24%, I hypothesise that if the United States increases production, the supply of
crude oil will increase, and prices of oil will decrease. Upon running my regression to create
robust estimates, I found, all else equal, that at the 1% level of significance, if U.S. oil
production increase one percent, the estimated price of crude oil under the NYMEX would
decrease by $1.62, and $1.34 under the Brent crude index.
given the same period, if OPEC increases production, I expect the price of oil to
decrease, where with Brent crude oil i found, at the 5% level of significance that if OPEC
increases production by one percent, price of Brent oil declines by $1.61. However, there is a
lack of evidence to statistically prove an effect on NYMEX oil prices.
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10. Market Share:
In developing my market share variable, I gathered quarterly data on global crude oil
production and crude oil produced by my variable of interest. In producing U.S. market share
, I simply divided U.S. total oil production by total oil produced globally( )A
Ct
(A )t
US
C )( t
World
, and similarly OPEC market share was total oil produced by OPEC , divided by)(B
Ct
B )( t
OPEC
total oil produced globally .(C )t
World
If OPEC market share increases, all else held constant, I would hypothesis that)(B
Ct
Prices would increase as OPEC gains more market power in controlling and manipulating
prices. My analysis shows for the prices of NYMEX and Brent oil, that at the 5% level of
significance, all else equal, as OPEC market share increases by one percent, prices of crude
oil would increase by $0.06 and $0.08 respectively.
In hypothesising the effect of U.S. market share on the price of oil, holding all( )A
Ct
else equal including U.S. oil production, if OPEC decreases production in hopes of increasing
prices, U.S. Market share increases and so do prices. All else equal, at the 1% level of
significance a one percent increase in U.S. market share causes prices in the NYMEX index
to increase by $0.18, And at the 10% level of significance; Brent prices will increase by
$0.13 for every one percent increase in market share.
Inventory:
In examining inventory, I will analyze the impact of changes in above-ground
inventory held by the United States.
If U.S. Inventory (excluding SPR) increases, I expect crude oil prices to decline, as a
result of a smoothing effect. In this case I have no sufficient evidence to reject the null
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11. hypothesis, that a change in oil stock held by the U.S. that excluding Strategic Petroleum
Reserves has any effect on crude oil prices for both the NYMEX and Brent indices.
However, with Strategic Petroleum Reserves, I hypothesis that an increase in SPR
will result in an increase in prices. Where, if the United States increases SPRs, consumers
will see this as a negative sign and increase speculation which increases demand for crude oil,
driving prices up. All else equal, I found sufficient evidence at the 1% level of significance
that if SPR increase one percent, estimated NYMEX prices increase by $1.56; and estimated
Brent prices also increase by $1.68.
Other Regressors:
I will be using U.S. active oil rigs as a proxy for abundance/scarcity rent and the
availability of extraction. If an exogenous event occurs, such as the discovery of new wells or
an increase in consumer demand, I expect an increase in extraction activities of oil rigs in the
United States, increasing supply, resulting in a decline in oil prices. I found that my result,
though significant, are not consistent with my hypothesis, and hence I fail to reject my
hypothesis.
When accounting for income, I will be examining the impact of GDP per capita to the
price of crude oil. I expect, as GDP per capita increases, income would increase, which
increases consumption demand for all good. An increase in demand would then increase
quantity demand of crude oil and in turn prices. My results find this to be true at the 1% level
of significance for both indices. where, all else equal, if U.S. GDP per capita increases by one
percent, estimated crude oil prices under the NYMEX would increase by $1.87; and
estimated Brent oil price would increase by $1.70
4. Conclusion
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12. I set out to find evidence of whether or not changes in the supply of crude oil in the
global commodity market would have any impact on the price of crude oil. I’ve found results
after conducting empirical robust OLS analysis, from the data sample I’ve gathered. That
there is ample and sufficient evidence that changes in U.S. oil supply and production have an
effect on crude oil prices for both the New York Mercantile Exchange price index and the
Brent oil price index. Some similarities or differences in the prices of oil per index can be
found in my results, which can be traced to various elements involving the crude oil market.
I've omitted such arguments for purposes of redundancies and inconsistencies, and to satisfy
my restricted model, I could say i'm satisfied with the results.
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13. 13

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