Blog Post

Is the oil price-GDP link broken?

Oil prices fell to a 12-year low at the beginning of 2016. We find that the drop in the past two years was primarily driven by expectations. In fact, changes in oil prices since 2008 are increasingly explained by expectations. In the past, expectation-driven oil prices drops were good news for the EU economy. However, the declining importance of actual changes in demand and supply for oil prices raises doubts about whether we can still expect a positive impact on EU GDP.

By: and Date: March 31, 2016 Topic: Energy & Climate

By February 2016, the price of oil had fallen to about 30 USD —from about 100 USD per barrel in 2014. There are three possible causes: real changes in supply, real changes in demand and changes in expectations regarding the future oil demand-supply balance.

Oil supply continued to increase in 2015, as US shale oil production was more resilient than previously thought, and countries like Iran returned to the market. In addition, OPEC, a cartel of oil exporters, is not restricting supply. As a result, at the end of 2015, oil production had increased by about 3 percent compared to the 2014 average: from 86 to 88.5 million barrels per day. The International Energy Agency foresees that the world will be “awash in oil” in the near future[1]. This increasing supply put downward pressure on oil prices.

Figure 1: oil production 2014 vs. January 2016 in million barrels per day

Source: OPEC

Fig1

Currently aggregate demand is sluggish. Growth in emerging market economies is slowing and macroeconomic risks in developed countries persist. This reduces oil demand and hence puts additional pressure on oil prices. Finally, price developments are not only explained by changes in real demand and real supply, but also by market actors’ expectations about the future demand-supply balance.

The impact of lower oil prices on the EU economy depends on the relative importance of these three drivers. We find that in the last three years about 12% of the oil price decrease can be attributed to a fall in aggregate demand and 15% to an increase in current oil supply. 73% of the price drop can be attributed to expectations about the oil demand and supply balance. This is the finding of an analysis based on Kilian (2009), where we decompose oil price shocks into these three elements by estimating a structural VAR model in which the oil price reacts – with some delay – to changes in monthly oil supply and a measure of economic activity. Essentially, we update the analysis of Kilian and apply it to the EU economy.

Figure 2: Aggregate oil price shocks from 2000 until 2016

Source: own calculation

Fig2

What does this imply for the EU economy? Past experience has shown that the three components have structurally different impacts on the economy (see graph):

  • A supply shift has no significant impact on EU GDP within the following three years. Hence, the impact of increasing supply in 2015/2016 should not boost GDP.
  • Higher aggregate demand, that also caused oil prices to rise, let to even higher GDP 18 month later. Hence, the lower aggregate demand that caused oil-prices to decrease in 2014 and early 2016 should have a depressing effect on GDP – while the positive demand shock identified for 2015 should have an inflating effect on GDP. Overall, the magnitude of the negative aggregate demand shock should prevail.
  • Finally, expectations regarding the future oil demand-supply balance which drove down oil prices used to have a positive impact on GDP. Consequently, the observed lower oil prices, which are primarily driven by such expectations, might well be a good sign for the EU economy.

Figure 3: Effect of oil price shocks on EU GDP growth; GDP is measured in USD, seasonally adjusted and expressed in log differences

Source: own calculations

Note:  relative q-o-q percentage change of GDP due to a 1 percent change in oil price due to a supply/demand/expectation shock. The solid lines correspond to pint estimates; dotted and dashed lines identify one- and two- standard error bands, respectively.

Fig3

Fig4

Fig5

The most striking result of this decomposition is that the role of expectations has dramatically increased since 2008. The data imply that that it is very unlikely (less than 5% probability) that oil prices after 2008 are driven by the same combination of factors as before 2008. In fact, expectations regarding the future oil demand-supply balance seem to have become the main driver of oil price changes. This would be consistent with a hypothesis that oil markets are becoming more detached from observable supply-and-demand fluctuations (one possible explanation being loser monetary policy).

In conclusion, the observed drop in oil prices should have a slightly positive in pact on the EU economy. However, this prediction presumes that past relations between oil demand, oil supply, oil prices and GDP still hold. In fact, the structural increase in the importance of expectations in oil price formation raises doubts about the stability of these past relations. The true impact of the oil price drop therefore remains to be seen — and could prove disappointing in the end.

Very helpful comments by Zsolt Darvas are gratefully acknowledged. All remaining mistakes are the author’s sole responsibility.

Annex: Methodology

[1] https://www.iea.org/oilmarketreport/omrpublic/


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic More by this author

Podcast

Podcast

Deep Focus: Renewing the clean energy strategy in the Mediterranean

In this episode of Deep Focus, Bruegel research fellow Simone Tagliapeitra explains how the nature of cross-Mediterranean energy relations needs to change, not only in line with new climate-change targets but also to meet the burgeoning energy demand outside Europe.

By: The Sound of Economics Topic: Energy & Climate Date: October 16, 2018
Read article Download PDF More on this topic More by this author

Policy Brief

The Euro-Mediterranean energy relationship: a fresh perspective

The author analyses the current renewable energy development in Southern Mediterranean countries (SMCs) and proposes a climate financing strategy that retreats from the Eurocentric approach. Not only will it allow the region to meet its energy demand sustainably, it will also benefit the EU, both in economic and political terms.

By: Simone Tagliapietra Topic: Energy & Climate Date: October 16, 2018
Read about event

Past Event

Past Event

Policy responses for an EU-MENA shared future

In the third edition of the "Platform for Advanced & Emerging Economies Policy Dialogue" we will discuss trade flows and trade policy between Europe and MENA, integration of developing economies into global value chains, and regional energy relations.

Speakers: Karim El Aynaoui, Marek Dabrowski, Uri Dadush, Ignacio Garcia Bercero, Ettore Greco, Giuseppe Grimaldi, Badr Ikken, Joanna Konings, Said Moufti, Pier Carlo Padoan, Lia Quartapelle, Visar Sala, Nicolò Russo Perez, Nicolò Sartori, Simone Tagliapietra and Guntram B. Wolff Location: LUISS Business School Viale Pola, 12, 00198 Roma RM, Italy Date: October 11, 2018
Read article Download PDF More on this topic More by this author

External Publication

The impact of global decarbonisation policies and technological improvements on oil and gas producing countries in the Middle East and North Africa

Simone Tagliapietra contributed to the IEMED Mediterranean Yearbook 2018 with a chapter on the impact of decarbonisation policies on oil and gas producing countries in the MENA region.

By: Simone Tagliapietra Topic: Energy & Climate Date: October 3, 2018
Read article Download PDF More on this topic More by this author

External Publication

Electrification in sub-Saharan Africa: The role of international institutions

Bruegel fellow Simone Tagliapietra contributed to the new issue of the 'Oxford Energy Forum' with an article on the role of international and European financing institutions in fostering the electrification of Africa.

By: Simone Tagliapietra Topic: Energy & Climate Date: September 11, 2018
Read article More on this topic

External Publication

Energy in Africa: Challenges and Opportunities

Bruegel fellow Simone Tagliapietra co-authored a new book on energy in Africa.

By: Manfred Hafner, Simone Tagliapietra and Lucia de Strasser Topic: Energy & Climate Date: September 5, 2018
Read article More on this topic More by this author

Blog Post

Ukraine: The struggle for reforms continues

The modernisation of the Ukrainian economy and state continues to develop at an unsatisfactory pace due to a lack of pro-reform political consensus. The two upcoming election campaigns in 2019 (presidential and parliamentary) make the reform process even slower and additionally put its effectiveness and sustainability under risk. The international community has a limited toolkit to overcome this stalemate.

By: Marek Dabrowski Topic: Global Economics & Governance Date: July 4, 2018
Read article

Parliamentary Testimony

European Parliament

Brexit and Energy Policy

Testimony before the European Parliament's Committee on Industry, Research and Energy

By: Simone Tagliapietra and Georg Zachmann Topic: Energy & Climate, European Parliament, Testimonies Date: May 28, 2018
Read about event More on this topic

Past Event

Past Event

Cleaning up Europe's transport sector: which strategies?

Over the last decade, EU’s greenhouse gas emissions have decreased significantly in all sectors with the only exception of transport. This sector is thus becoming a key obstacle to EU decarbonisation and more aggressive policies are needed to decarbonise it. This event discussed the potential strategies to structurally address this issue, also on the basis of Bruegel’s new policy proposal in the field.

Speakers: Maria Demertzis, Francesco Starace and Simone Tagliapietra Topic: Energy & Climate Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 3, 2018
Read article More on this topic More by this author

Podcast

Podcast

Brexit consequences for EU climate and energy policy

Bruegel fellow Georg Zachmann joins Richard Tol, professor in the Department of Economics at the University of Sussex, and Pieter-Willem Lemmens, head of analysis at the climate policy think-tank Sandbag, for this episode of 'The Sound of Economics', to discuss the impact of Brexit on climate and energy policy in the European Union.

By: The Sound of Economics Topic: Energy & Climate Date: February 15, 2018
Read about event More on this topic

Past Event

Past Event

Impact of Brexit on the EU energy system

This meeting will build on Bruegel’s recent report for the European Parliament (link) and will consist of two sessions. The first session will discuss the impact of Brexit on the EU energy sector, with a special focus on the consequences of Brexit for the Irish energy system. The second session will look at the impact of Brexit in terms of […]

Speakers: Georg Zachmann, Richard Tol and Pieter-Willem Lemmens Topic: Energy & Climate Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: February 8, 2018
Read article More on this topic More by this author

Blog Post

EU budget: Expectations vs reality

The public's impressions of where money is spent in the European Union can often be wide of the mark. But whether this is a result of wishful thinking or just a lack of information remains unclear.

By: Yana Myachenkova Topic: European Macroeconomics & Governance Date: January 29, 2018
Load more posts