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posted on 13 September 2015

Evaluating A Year Of Oil Price Volatility

from the Kansas Fed

-- this post authored by Troy Davig, Nida Cakir Melek, Jun Nie, A. Lee Smith, and Didem Tuzemen

Over the last 14 months, the average price of oil has fallen by about 60 percent. Oil prices fluctuate for a number of reasons. Rising global economic activity can increase demand and push prices higher, while rising production rates can cause prices to decline. Although simple supply and demand stories are useful in describing oil price movements, the factors driving such changes are often difficult to identify. As a result, large swings in oil prices can come as a surprise, as was the case with the recent decline starting in mid-2014.

The recent period of price volatility is not unique. Oil prices also fell by over 50 percent during the Great Recession of 2007-09. However, the price decline during the Great Recession was due primarily to a pronounced slowdown in global economic activity. Soft global demand during this period also caused prices for commodities other than oil to fall sharply. Prices for some of these commodities, such as copper, fell again in 2014, but nowhere near the extent of oil prices. These movements suggest that only a portion of the decline in 2014 is likely due to weaker global economic activity.

Increasing supply may be another explanation for the oil price decline that started in 2014. Total global oil production increased 3.7 percent year over year as of December 2014. This increase is on the higher side, though not remarkable by the standards of the past five years (Oil & Gas Journal). However, prices are affected not only by changes in the level of production, but by changes in production relative to what the market expected. Higher production levels in the United States due to new technologies were to some extent expected. But some developments on the supply side were unexpected, such as the comeback of Libyan production, the unwillingness of the Organization of the Petroleum Exporting Countries (OPEC) to reduce supply, and the probable future re-emergence of Iran on the global oil market, which likely caused shifts in expectations of future oil supply relative to demand.

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Source: econrev/econrevarchive/2015/3q15davigetal.pdf

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