Crude or Refined: Identifying Oil Price Dynamics Through the Crack Spread

Abstract

This paper proposes a new methodology for differentiating oil demand and supply shocks using the information content of forward-looking market prices for crude oil and refined product crack spreads. Building upon the folk wisdom that demand and supply shocks have asymmetric pass through dynamics in energy financial markets, the paper provides two complementary identification schemes, based on sign restrictions and heteroskedasticity. Both approaches produce very similar historical decomposition of oil price movements. Our results suggest that the price rises of the late 1970s had a demand-driven component, the 1990-91 Gulf War shock reacted both to supply and precautionary demand shocks, and the recent price spike in 2008 was driven more by expectations of future supply constraints than immediate demand pressures. Oil demand and supply shocks, by our decomposition, are shown to have different impacts and reactions to macroeconomic variables such as industrial production, unemployment, core inflation, and the Fed Funds rate, with implications for formulating an effective policy response to oil shocks.