METU AHMET GLVEREN

FEAS 2011674

IR 448

ABSTRACT

This paper provides informative and critical perspective about the selected

articles of Lutz Kilian, who is professor of economics in Michigan University.

Selected five articles discusses the effects of oil prices shocks from different

perspectives. Not only reasons of oil price fluctuation but also consequences of

shocks taken into account from recent history to 21st century for US and World

economies. At the end of the paper, we will have documented how oil prices

shocks affect decision of households, producers, financial market agents and

policy-makers economically.

1. INTRODUCTION

Lutz Kilian, Professor of Economics, received his Ph.D. in Economics from

the University of Pennsylvania in 1996. Much of his recent research is

concerned with the sources of fluctuations in the price of oil, with the

transmission of oil price shocks, with the role of speculation in oil markets, with

measuring oil price expectations in financial markets, and with oil price
forecasting. His research interests also include time series econometrics,

empirical macroeconomics.

Oil price have been the one of the most important determinants of the oil

market and energy diplomacy since oil became heavily used in industry in early

20th century. Powerful actors in energy markets has tried to influence and

control oil prices in order to be better off in industrialization race because it is

used as a primary input in almost all industrial sectors. On the other hand, major

oil producer such as Russia, Iraq or UAE also heavily depend on oil prices

because oil export has a great share on development of these countries.

Uncertainty and fluctuations in crude oil prices causes unstable market

environment that undesirable consequences for market participants. However,

oil prices are considered one of most unstable commodity prices for a long year.

Figure 1 shows that West Texas Intermediate(WTI) average annual barrel prices

in terms of US $ since 1976. As it can be seen in Figure 1, crude oil prices in

spot market (WTI) have fluctuated for forty years despite of the fact that most of

the actors desire the stability of oil prices. Many economist focused on this

instability of oil prices in terms of forecasting oil price shocks, estimating

impact of oil prices shocks on macroeconomic variables such as real output,

inflation(CPI), trade balances. Lutz Kilian is a successful scholar who focus on

this issue. Before analyzing the studies of Killian, I want to emphasize some

concepts which are mostly used in articles of him.

 Figure 1
120
100
80
60
WTI (US$ Per Barrel 40
20
0

1976-2017

1.1 OIL PRICE SHOCKS

The unanticipated or surprise component of a change in the price of referred

to as an oil price shock. By comparing oil price expectations to subsequent

outcomes, we may obtain a direct measure of the magnitude of the shock.

Clearly, whether an oil price shock occurred, and how large this shock was,

depends on which measure of the oil price expectations we use. There are three

perception among economist about the definition of price shocks. One is C

Specification which takes into account all price changes in oil prices as an oil

price shocks. Second one is LC Specification which assumes firms and

household do not respond small changes in oil prices, but respond large one

because for example, the presence of costs to monitoring energy expenditures

and of costs of adjusting consumption patterns might make households reluctant

to respond to small energy price changes. The last one is called NC

Specification which is defined as the difference between the current price of oil

and the maximum price over the previous year (or alternatively the previous
three years) if the current price exceeds the previous maximum, and zero

otherwise

1.2 VAR MODEL

One of the highlighted concept which is frequently used by Lutz Kilian is

Structural VAR (Vector Autoregressive). VAR models are among the most

widely used econometric tools in the fields of macroeconomics and financial

economics. Much of what we know about the response of the economy to

macroeconomics shocks and about how various shocks have contributed to the

evolution of macroeconomic and financial aggregates is based on VAR models.

VAR models have been used successfully for economic and business forecasting

for modeling risk and volatility, and for the construction of forecast scenarios.

Lutz Kilian is one of the user of structural VAR model to measure impact of oil

price shocks on macroeconomics variable. In empirical analysis of Kilian

(2014), he employs a VAR model by using C specification that includes the

real price of oil, global crude oil production, global real economic activity and

change in global crude oil stocks with 12 lagged variables which means any

change in variables before 12 months can affect todays real oil price. Moreover,

these models do not distinguish between energy price innovations driven by

supply shocks and demand shocks in energy markets. The latter distinction can

be crucial because different demand or supply shocks in energy markets tend to

elicit different responses of macroeconomic aggregates.

 1.3 OTHER LITERATURE

It is widely accepted that energy prices in general, and crude oil prices in

particular, have been endogenous with respect to U.S. macroeconomic

conditions dating back to the early 1970s. Endogeneity here refers to the fact

that not only do energy prices affect the U.S. economy, but that there is reverse

causality from U.S. and, more generally, global macroeconomic aggregates to

the price of energy. Clearly, both the supply of energy and the demand for

energy depend on global macroeconomic aggregates such as global real

economic activity and interest rates. Economist and statistician need to use

statistical transformation to extract the exogenous components of oil price. The

leading example of this approach is the net oil price increase measure proposed

by Hamilton (1996, 2003). Hamilton (2003) suggests that, although the price of

crude oil itself is not exogenous with respect to U.S. macroeconomic aggregates,

a suitable nonlinear transformation of the price of oil (based on the amount by

which nominal oil prices exceed their maximum value over the previous three

years) is. The purpose of the statistical transformation of oil prices is to isolate

the component of the price of crude oil that can be attributed to political events

in the Middle East, which in turn are exogenous to global macroeconomic

conditions. Hamilton concludes that relationship effectively represents a causal

relationship, lending credence to the practice of treating net oil price increases as

exogenous. According to Kilian, the fact that net oil price increases are not

measures of exogenous oil price shocks can also be seen more directly. Kilian
(2008b) shows that oil price shocks detected by the nonlinear transformation

proposed by Hamilton (2003) occur at times when exogenous oil supply shocks

in the Middle East were conspicuously absent and that there are major

exogenous events that are not followed by oil price shocks. Hence, oil price

series must be treated as endogenous whether they have been transformed to net

oil price increases or not.

2.1 1st Article The Economic Effects of Energy Price Shocks

This article widely focus on the response of macroeconomics of economic

variables against the energy price shocks. Energy prices are separated from other

commodity prices in terms of four extent. Firstly, energy prices change sharply

and profoundly which is different than other commodities. Secondly, demand for

energy is inelastic. For example, households cannot shut down their heating

thermostat easily even gasoline prices rise high. Third factor is that energy

prices is also determined by exogenous events in Middle East. Final reason is

that, major oil price increases have accompanied with recessions and inflations

in history.

Energy series have been obtained according to share of usage of

electricity, gasoline, crude oil, oil in time series used by Kilians papers. Then he

employs a VAR models to measure effects of energy price changes in

hypothetical state. Before conducting VAR analysis, he describes the main

transmission channel of energy prices on macroeconomy. That is, he shows

which channels transmit energy price changes to firms and household decision.

There are four direct effect of energy price changes on households decision

directly. One of the transmission mechanism is that higher energy prices reduces

discretionary income, which is remaining income left after energy bills are paid

(discretionary effect). Second, higher energy prices make durable goods

consumption postponed by creating uncertainty on future expectation

(uncertainty effect). Third mechanism is that consumer might increase their

precautionary saving by thinking there might be recession and unemployment in

future (precautionary effect). Last one is that consumers might decrease their

consumption durables which consumed together with energy such as automobile

purchases. These four direct effect is covered largely on literature, on the other

hand there are also indirect effect such as the fact that consumers purchases

switch toward to more energy-efficient durables in automobile sectors or heating

sector. Moreover, there are also transmission mechanism that links energy price

changes to firms decision on investment purchases. Two channels of energy

price changes to investment decision is that firms decrease production amount

because of higher energy costs and reduced demand from consumers.

After stating transmission mechanism for consumption and investment

decision, Lutz Kilian analyzes the effect on energy prices on consumption and

investment decision. In other words, he measures how energy expenditures, non-

energy expenditures and investment expenditures in response to unit increase in

energy price in hypothetic environment. Firstly, we look at energy demand

responses. The strikingly large response of 1.47 for heating oil and coal is

likely due to households ability to store heating oil in tanks. This storage feature

allows households to delay purchases of new heating oil when the price of

heating oil is high and to fill the tank completely when prices are low. In

contrast, electricity and natural gas are inherently unstorable, and gasoline may

not be stored for safety reasons beyond the tank capacity of a car. Indeed, the

declines in electricity consumption and in natural gas use are smaller and not

statistically significant. Secondly, he will look responses of non-energy

consumptions. There is not significant effect of energy price changes on overall

non-energy consumption, but automobile industry is exception. Data shows us

unanticipated 1 percent increase in energy prices causes highly significant

decline of -0.76 percent the consumption of motor vehicle and parts. The most

affected subsector is pleasure boats, pleasure aircrafts and recreational vehicles

consumption, whose declines reach -1.58 percent. In contrast, change in

motorcycle consumptions remain insignificant. However, these sectors make up

small share on motor vehicle consumption comparison to automobile sales.

Elasticity of new automobile demand is -0.71 which is statistically significant.

When we look deep in subsectors of automobile industry, we can show the how

consumers smooth their consumption from SUV cars to energy efficient

vehicles. Although, elasticity of new foreign auto, which is known better energy
efficient than American cars, is very low and statistically insignificant, SUV

sales drop -1.5 percent as a result of one percent increase in energy prices.

Lastly, we look at response of investment decision. The overall effect of energy

prices changes is very low in response to increase in energy prices. However,

there is positive correlation between mining industry and energy prices. As

energy price rises one percent, investment on mining industry rises +1.39

percent. On the other hand, there is significant decline (-1.02) in residential

investment (purchases for new houses). Then Kilian conclude that energy prices

shocks mainly hit automobile and housing sectors in U.S economy.

The other analyze conducted by Kilian in this paper is that he tries to

distinguish supply shock effect, demand shock effect and oil specific demand

shock. In much of the earlier literature, supply shocks are much emphasized on

energy prices changes as in 1974 Oil crises. However, Kilian argue that demand

shocks and oil specific demand shocks have much more importance on the

energy prices. Figure 2 shows us oil supply shock has statistically insignificant

effect on real price of oil. On the other hand, demand side shock has persistent

and profound effect on energy prices. Oil specific shocks mainly caused by
precautionary purchases by households and firms when prices are low.

Figure 2

Kilian conclude that demand side shocks dominated the energy prices as

contrary to general belief since 1973. Then we can suggest that oil price increase
between 2003-2008 is originated by unanticipated increase demand for input

commodity in emerging Asian economics, mainly China and South Korea. In

addition, impact of supply shock on 1973 oil embargo might be very less than

perceived. The alternative explanation might be the increasing precautionary

demand before the embargo might lead to 4 times increase in energy prices in

U.S.

2.2 2nd Article Oil and the Macroeconomy since the 1970s

Lutz Kilian stressed in this paper that how relationship between main

economic variables such as GDP, inflation and productivity and oil prices have

been evolved since 1970. It is commonly believed that there is a close link from

political events in Middle East to changes in the price of oil, and in turn from oil

price changes macroeconomic performance in the United States. As to the first

belief, Kilian stressed that exogenous political events in the Middle East are but

one of several factors driving oil prices, and that the effect of seemingly similar

political events may differ greatly from one episode to the next, in accordance

with variations in demand conditions in the oil market and global

macroeconomic conditions second belief, he showed that the timing of oil price

increases and recessions is consistent with the notion that oil price shocks may

contribute to recessions without necessarily being pivotal. Killian have been

investigated several leading theoretical explanations for a contractionary effect

of oil price increases, but found little empirical support for any one explanation,

either because the magnitude of the predicted effect can be shown to be small a

priori or because the theory has implications that are not supported by U.S.

macroeconomic data. It is also showed that oil price shocks are not sufficient to

cause recession in U.S alone, although we know that oil prices cause decline in

real output. On the other hand, oil took small place on the U.S productivity to

change it. Although a number of additional and more elaborate arguments have

been advanced that in principle might establish a link from oil prices to

productivity changes, none of these models can claim solid empirical support.

Moreover, Kilian investigated impact of oil prices on CPI(inflation). Stagflation

as an economic term was emerged in 70s and refer to both decline in Gross

Domestic Product and raise in price level(inflation). After oil crises in 1973,

there was the strong belief the relationship between oil prices and general price

level in U.S. However, this relationship is not apparent when we look at the real

data. For example, outbreak of war between Iran and Iraq seem to have had little

impact on CPI inflation as well as the invasion of Afghanistan 2001 and

invasion of Iraq 2003. Thus, we conclude that disturbances in the oil market are

likely to matter less for U.S. macroeconomic performance than has commonly

been thought.

The other issue that explained by Kilian is where the origin of oil price

shock came from. He finds a solution to determine which variable or exogenous

events play a role on price of oil. The role of OPEC is considered important on
price of oil because OPEC meeting in 1999 was considered main reason of the

peak in the oil prices in 2001 in March. Such a cartels formation is conducive

when real interest rates low as in 1970s, but it is detrimental when interest rates

high for oil producer. Thus, strong economic expansion could strengthen oil

carters and major recessions weaker them. Under the light of this information,

we can see that pending recession in U.S because of effects of Asian crises in

1997 might be the underlying reason of reformation of OPEC in 1999. Thus, we

can conclude that this analysis does not deny the importance of political efforts

aimed at strengthening or sustaining the oil cartel; rather, the point is that such

activities -unlike wars- are not exogenous and that the sustainability of cartels

will be determined to an important extent by the macroeconomic environment.

Second, the role of political events and wars in Middle East. It is widely

believed that sudden and large changes in the price of oil tend to be caused by

unpredictable exogenous political events in the Middle East that represent shifts

of the supply curve for oil. Often these "shocks" are associated with military

events such as the outbreak of wars. Figure 3 show the imported oil price

changes in US between 1971-2003. Clearly, not all so-called oil shocks follow

the same pattern. For example, the period after the October war of 1973, the

period after the collapse of OPEC in late 1985 and the period immediately after

the invasion of Kuwait in 1990 are characterized by sharp spikes in oil prices.

The period following the Iranian revolution of 1978-1979 and that following the
1999 OPEC meeting are, in contrast, characterized by relatively small, but

persistent positive rates of change.

We conclude that there may have been many plausibly exogenous political

events in the Middle East, but the magnitude and pattern of the subsequent

changes in the price of crude oil varies greatly. Thus, it is far from obvious what

the precise channel is by which exogenous events affect the price of oil and

whether there is a link at all. The explanation is also valid for the role of oil

embargos in World. As we can see, neither cartels nor political events, wars and

embargoes can be seen as a major source of oil price shock in near history.

Apart from their indirect effects through institutions, macroeconomic conditions

also affect the price of oil directly by shifting demand for oil.

The importance of shocks to the demand for oil was strikingly illustrated

by the drop in the price of oil following the Asian crisis of 1997-1998. Unlike in
the late 1990s, the upward pressure on oil prices in the 1970s, in this view, was

caused not by a shift in productivity, but by worldwide monetary expansions that

drove output levels above potential for sustained periods and were followed by

periods of unusually low real interest rates. As these booms gave way to

recessions and increases in real interest rates, oil prices started falling in the

early 1980s and ultimately collapsed in early 1986, despite the best efforts of the

OPEC cartel to sustain them at higher levels.

As we can see, main determinants of oil prices have been endogenous to

the macroeconomic variables. Also, we can see these demand effect between

2003-mid 2008 oil prices were raised together with the unexpected demand in

Asian economies. Then, it was declined with the slow-down in economic

activity after 2008 Global Financial Crises.

2.3 3rd Article Forty Years of Oil Price Fluctuations

It has been 40 years since the oil crises in 1973/74. Most of thing about

the oil market have been changed. For example, new regime in the global crude

oil makes possible to fluctuation in response to forces of supply and demand.

Governments gave up the restrictions on the oil prices because restriction

created market disequilibrium in oil consuming country. Empty highways, long

order in gas station is known pictures from the 70s all over World. Thats why

America lifted the restriction and regulation in oil market such as price celling

and quantity ceiling that distort market equilibrium. However, even these

regulations cannot prevent the economies from unanticipated oil price shocks.
 Lutz Killian states the concise history of the oil price shocks before he

analyzes the reason why oil price expectation and real prices do not match. For

example, the well-known reason of 73-74 crises is the decline in supply because

of the embargo, but there was no fighting in any Arab oil producing countries

and no oil facilities have been destroyed. Instead this war took place in Egypt,

Israel, Syria which are not a major oil producer. There is production cut imposed

by some Arab countries approximately %25 percent. However, there were an

agreement between this countries and western oil importer countries that fixed

the oil price for a long time. Also, Kuwait and Saudi oil production was higher

than the normal capacity. In other words, production cut has only reversal effect

on the level production. 75% percent of the increase in the oil prices was caused

by global increase in the demand for non-oil commodities as Kilian argued.

After mentioning the demand sided reason of the important oil price shocks, his

analysis focused on the question of how this surprise component or shock

component of oil price fluctuations is. It is illustrated that the timing and

magnitude of oil price shocks depends on the measure of oil price expectations.

The reason why economists care about oil price shocks that these shocks

affect economic decisions. One channel of transmission is the loss of

discretionary income that is associated with unexpectedly higher oil prices hence

higher gasoline prices. Consumers who are forced to commute to and from

work, for example, often have little choice, but to pay higher gasoline prices,

which reduces the amount of discretionary income available for other purchases.
Another channel is that oil price shocks affect expectations about the future path

of the price of oil. Such expectations enter into net present value calculations of

future investment projects, the cash flow of which depends on the price of oil.

For example, automobile manufacturer's decision of whether to build new

production facilities for a sport utility vehicle is directly affected by the price of

oil, as is a household's decision which car to buy. What matters for net present

value calculations is not the magnitude of the oil price surprise in the current

period, but the revision the expected path of the future price of oil which enters

the cash flow. In addition, oil price shocks also affect the cash flow of earlier

investment decisions by manufacturing firms. In general, ongoing projects

remain profitable as long as the price exceeds the marginal cost, which depends

on the current price of oil. It is even possible for higher oil prices to cause

ongoing projects to be abandoned (much a consumer may choose to scrap a gas-

guzzling car in response to higher gasoline prices). For this reason, oil prices

continue to surprise us.

2.4 4th Article Oil Price Shocks, Monetary Policy and Stagflation

The analysis in this paper suggests that neither diminished real-wage

rigidities nor improved monetary policy responses to oil price shocks are a

plausible explanation of the increased resilience of the US economy to oil price

shocks and of the absence of stagflationary responses since the mid-1980s.

Rather, the increased resilience of the US economy can be traced to changes in

the composition of the oil demand and oil supply shocks underlying the real
price of oil. In particular, the surge in the real price of oil between 2003 and mid

2008 was driven almost entirely by a sequence of unexpected increases in the

global demand for industrial commodities. These global aggregate demand

pressures more than offset increases in the production of crude oil over the same

time period. The resulting oil price increases reflected a persistent shift in the

scarcity of oil, leaving little room for monetary policy-makers in oil-importing

economies to cushion the impact of this shock. There is no evidence that oil

supply shocks or speculation in oil markets played a significant role.

Since positive global aggregate demand shocks entail a stimulus for oil-

importing economies, and since they raise oil prices and other industrial

commodity prices only with a delay, their short-run effect on real GDP tends to

be more benign than that of other oil demand or supply shocks. Only as that

initial stimulus fades will the recessionary effects dominate. Thus, rising oil

prices and a robust economy may coexist for several years, as long as the

economy is sustained by repeated positive global aggregate demand shocks. The

end of the demand boom, however, will be associated with a recession. The data

indicate that global demand peaked in May 2008 and collapsed in the second

half of 2008. Econometric models suggest that the drop in the real price of oil in

the second half of 2008 reflected both sharply reduced global aggregate demand

and the anticipation of a sustained global economic recession.

The 20032008 oil price shock episode has been different from the 1970s

in that there is no sign that stagflation has made a comeback, although the surge
in the real price of oil was larger than even in the 1970s. Kilian has shown that

the likely explanation of the absence of stagflation is the choice of a monetary

policy regime that emphasizes the price stability objective. Indeed, many central

banks have been remarkably successful at keeping inflation expectations

anchored and stable in an environment of high and rising oil prices.

2.5 5th Article Oil Shocks and External Balances

This paper provided the most comprehensive analysis to date of the

effects of oil demand and supply shocks on the external balances of oil exporters

and oil importers. Our analysis explicitly recognized that oil price changes

reflect at least in part the state of the global economy. He also distinguished

between oil price changes caused by crude oil supply shocks, oil price changes

driven by shocks to global aggregate demand for industrial commodities, and oil

price changes associated with oil-market specific demand shocks such as shocks

to the precautionary demand for oil.

Study of Kilian complements recent theoretical advances in modeling the

effects of oil demand and oil supply shocks on external balances. This

theoretical work has highlighted the importance of empirical studies of how

external accounts respond to oil demand and oil supply shocks. For example,

economic theory is informative about the direction and overall pattern of the

response of the oil trade balance to an oil supply shock, but it is quiet about the

magnitude of the response in question. Likewise, depending on the degree of

financial market integration, the non-oil trade balance may not respond at all to
an oil supply shock or the response could be potentially quite large. In addition,

to date there has been no theoretical analysis of global aggregate demand shocks

in industrial commodity markets. The effect of such shocks on external balances

tends to be rather complicated, making it difficult to generate any theoretical

predictions. These facts make the empirical analysis of the response of external

balances all the more relevant.

Key findings extracted from study are: (1) Global business cycle demand

shocks and oil-specific demand and supply shocks are important for the

determination of external balances. For example, they jointly account for 86% of

the variation in the current account of an aggregate of oil exporters and for 82%

of the corresponding changes in NFA positions (all expressed as a share of

GDP). Oil-market specific demand and supply shocks jointly account for about

half of the variation in changes in NFA positions, whereas demand shocks

associated with the global business cycle account for an additional one-third. For

an aggregate of major oil importers the corresponding shares are lower, but still

large.

(2) The nature of the transmission of oil price shocks depends on the

cause of the oil price increase. For example, positive oil demand shocks are

associated with a statistically significant accumulation of NFA in oil exporting

economies (and a corresponding decline in the rest of the world), whereas

negative oil supply shocks are associated with a statistically insignificant decline

in NFA. A second example is that a positive innovation to global aggregate

demand causes a current account surplus in oil-exporting economies that peaks

in years 2 and 3 after the shock, whereas an oil-market specific demand shock

causes a current account surplus in oil exporting economies that peaks

immediately in years 0 and 1.

(3) The overall effect of oil demand and supply shocks on the trade

balance of oil importers (and oil exporters) depends critically on the response of

the non-oil trade balance. Empirical evidence on the response of the non-oil

trade balance is especially useful because theory puts few restrictions on that

response. Moreover, the extent to which the non-oil trade balance moves in

response to external shocks sheds light on the degree of international financial

integration. Empirical results suggest that neither models of financial autarky

nor complete markets model provide a good approximation to the data, and

provide a benchmark for the construction of theoretical models of the

transmission of oil demand and oil supply shocks under incomplete markets.

(4) In addition to the adjustment of the trade balance and current account,

a second channel of adjustment is provided by valuation effects in the form of

capital gains or capital losses on foreign assets and liabilities. He found evidence

of systematic valuation effects in response to oil demand and oil supply shocks

for both oil exporters and oil importers. International financial integration

overall has tended to cushion the effect of oil demand and supply shocks on the

change in NFA positions of oil importers and oil exporters. Results highlight the

importance of incorporating trade in assets in theoretical models of oil price

shocks and suggest that theoretical models that ignore this channel of

transmission will not be consistent with the data. We concluded that in

predicting the effects of oil demand and supply shocks on external balances it is

necessary to consider not only the degree of an economy's international financial

market integration, but also its external portfolio configuration.

(5) Finally, our results are of interest for the recent policy debate about

external imbalances. His analysis suggests that shocks to the demand for

industrial commodities driven by the global business cycle have played a

significant role in recent years in the emergence of external imbalances.

Valuation effects, however, have helped cushion the impact of these shocks on

net foreign asset positions. For example, the widening imbalance in the U.S.

current account can be explained to a large extent by the cumulative effect of the

demand shock reflecting the global business cycle as well oil-market specific

demand and supply shocks, yet the impact of these shocks has been cushioned

by valuation effects, suggesting that the recent global oil demand shocks were

not as harmful to the U.S. economy as they would have been in the absence of

international financial integration.

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Economic Literature,46(4), 871-909.

Barsky, R., & Kilian, L. (2004). Oil and the Macroeconomy Since the 1970s.

Baumeister, C., & Kilian, L. (n.d.). Forty Years of Oil Price Fluctuations: Why
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Kilian, L. (2009). Oil price shocks, monetary policy and stagflation. London:

CEPR.

Kilian, L., Rebucci, A., & Spatafora, N. (2009). Oil shocks and external

balances. Journal International Economics,77(2), 181-194.

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