Oil price expectations are important, but not everyone has the same expectations. For example, policymakers tend to equate oil price expectations with the price of oil futures, which in turn may differ greatly from the true financial market expectation because the market rewards risk taking, as shown in recent research by the authors. Economists, in contrast, often infer oil price expectations from past data for key oil market indicators, whereas data in the Michigan Survey of Consumers suggest that U.S. consumers typically expect the price of oil to grow at the expected rate of inflation. So who is right? “Evidence shows that economists’ expectations tend to be more accurate than financial market expectations, the latter expectations are more accurate than policymakers’ expectations, which in turn are more accurate than consumers’ expectations,” says Professor Kilian, but the question about whose expectation comes closest to what actually happened isn’t the most interesting question to be asking.”
Differences in expectations also matter for understanding the real world. “If you are trying to understand whether a consumer will choose to buy a new car, what matters to understanding this decision is the consumer’s own oil price expectation, no matter how poor that expectation may perform by statistical criteria,” says Kilian. “Traditional models don’t make any allowance for the fact that different people in the real world operate under different oil price expectations. They impose the simplifying assumption that everybody agrees on the model structure being correct and forms their expectations in the same way. This assumption can be quite misleading in practice.”
Differences in oil price expectations also affect how we think about oil price shocks. An oil price shock occurs when the price of oil moves unexpectedly. The extent to which market participants are surprised by the ups and downs in the price of oil very much depends on what their expectations were. What may be shocking to a consumer, for example, may be anticipated by financial markets, and what financial markets foresee may be missed by a policymaker. These differences matter, for example, for understanding how the decline in the price of oil since June 2014 will affect the U.S. economy going forward and for how policymakers should respond. “We need to understand how decisions taken by people operating under potentially very different expectations jointly determine economic outcomes”, concludes Kilian.
The full article, "Forty Years of Oil Price Fluctutations: Why the Price of Oil May Still Surprise Us," can be found in the Winter 2016 edition of the JEP.
Kilian and Baumeister also co-wrote a column for Vox called “Expecting the Unexpected: Why the Oil Price Keeps Surprising Us.”
It typically takes several years to get a finished piece published in an academic journal, so what is Professor Kilian researching now? Two words: Shale oil. Shale oil is crude oil that cannot be extracted by conventional methods of drilling for oil because it is trapped in tight rock formations. It can only be extracted by a combination of horizontal drilling and the hydraulic fracturing (fracking) of the tight rock. These new technologies have resulted in an unprecedented boom in U.S. oil production since 2008 that only now shows signs of slowing down. As the supply of crude oil expanded in the United States and elsewhere, the price of oil has increasingly come under pressure, dropping from over $110 to close to $30 in January 2016.
Professor Kilian is investigating the implications of the U.S. shale oil boom for Arab oil producers. Because there is a U.S. oil export ban that prohibits exporting crude oil produced in the United States, we saw a glut of low-priced domestic crude oil in the central United States after 2010. As a result, domestic crude oil gradually began to displace U.S. crude oil imports from Arab and West African oil producers. These oil producers were hit even harder, when U.S. refiners turned domestically produced crude oil and oil imported from Canada into refined products such as gasoline or diesel fuel, and began selling these products to Europe and Latin America. Naturally, these countries cut back on their own crude oil imports in response, further undermining Arab oil exports.
Professor Kilian is currently quantifying how much higher the global price of crude oil would have been, if the shale oil boom had never happened, and how much oil revenues in countries such as Saudi Arabia have been squeezed as a result of this boom. The loss in Saudi oil revenue has fueled concerns about the political stability of the region and raised the question of how these countries should best respond to falling oil prices. The answer obviously depends on the extent to which the blame rests on U.S. shale oil producers.
In related work, Professor Kilian also examines the impact of the shale oil boom on the U.S. economy, debunking popular visions of the United States becoming independent of oil imports, of a possible rebirth of U.S. manufacturing, and of net oil exports offsetting the perennial U.S. current deficit. His research suggests that the domestic impact of shale oil is likely to be much more modest than has been widely believed.
To find out more about Professor Kilian's work, check out his website!