Understanding Crude Oil Prices*
James D. Hamilton
Department of Economics
University of California, San Diego
May 22, 2008
Revised: December 6, 2008
This paper examines the factors responsible for changes in crude oil prices. The paper
reviews the statistical behavior of oil prices, relates these to the predictions of theory, and
looks in detail at key features of petroleum demand and supply. Topics discussed include
the role of commodity speculation, OPEC, and resource depletion. The paper concludes
that although scarcity rent made a negligible contribution to the price of oil in 1997, it could
now begin to play a role.
*I thank Severin Borenstein, Menzie Chinn, Lutz Kilian, David Reifen, James Smith,
and four anonymous referees for helpful comments on earlier drafts.
How would one go about explaining changes in oil prices? This paper explores three broad
ways one might approach this. The first is a statistical investigation of the basic correlations
in the historical data. The second is to look at the predictions of economic theory as to
how oil prices should behave over time. The third is to examine in detail the fundamental
determinants and prospects for demand and supply. Reconciling the conclusions drawn from
these different perspectives is an interesting intellectual challenge, and necessary if we are
to claim to understand what is going on.
In terms of statistical regularities, the paper notes that changes in the real price of oil
have historically tended to be (1) permanent, (2) difficult to predict, and (3) governed by
very different regimes at different points in time.
From the perspective of economic theory, we review three separate restrictions on the
time path of crude oil prices that should all hold in equilibrium. The first of these arises from
storage arbitrage, the second from financial futures contracts, and the third from the fact
that oil is a depletable resource. We also discuss the role of commodity futures speculation.
In terms of the determinant