Facts and fiction in oil market modeling

Abstract

A series of recent studies has called into question the validity of traditional VAR models of the global market for crude oil. These studies seek to replace existing oil market models by structural VAR models of their own based on different data, different identifying assumptions, and a different econometric approach. Their main aim has been to revise the consensus in the literature that oil demand shocks are a more important determinant of oil price fluctuations than oil supply shocks. The purpose of this paper is to discuss the main differences between these competing approaches and to highlight the key points in dispute, including the way the priors are specified, the nature of the priors about the one-month price elasticity of oil supply, the pros and cons of alternative methods of econometric inference, the measurement of global crude oil inventories, oil consumption growth and global real activity, and the replicability of the results in Kilian and Murphy (2014). I make the case that the concerns regarding the existing VAR oil market literature have been overstated and that the results from these models are quite robust to changes in the model specification.