ECN 211 Assignment 4
Aggregate Supply Shock
25 Points

Last edit: 4/20/08

In the late 1970’s and early 1980’s, OPEC restricted their oil production and caused the world price of oil to increase significantly. The price tripled between 1978 and 1981. In the AS/AD model of the economy, we see this as a “supply shock,” and it sent many of the advanced economies of the world, including the US, into a recession.

Today, the price of oil is again going up. In 2004 it was around $37 and in 2005, it was $50. 2006 saw the price increase to $60 while it averaged $70 in 2007. Just recently it hit $114. Once again there is the potential for a “supply shock” to hit the US economy.

Let's suppose crude oil hits $110 and stays there. What we would like to know is how big the shock will be, and how does it compare to the one in ’78-’81.

To figure this out, we’re going to need some data. First some background information.

Crude oil is traded in markets around the world. Most of what you see reported in the press is the price for a particular grade of crude, usually West Texas Intermediate (WTI). This is a fairly light sweet crude that is easy to refine and yields a lot of gasoline. Heavier crudes trade at a discount to WTI because they require more processing and don’t yield as much of the high end products (gasoline, diesel, jet fuel…). Sour (high sulfur) crudes also trade at a discount to sweet crudes because the sulfur must be removed during processing.

What this means is that refineries usually have a crude oil acquisition cost that is below the WTI price since they buy and process a lot of the heavier sour crudes. To get a realistic refinery acquisition cost for crude oil, we’ll need to scale back the $110 price to about $95 for US refineries.

Refinery runs (production) are measured by gross input (crude oil) to distillation units since these are the first oil processing units in a refinery. Refinery runs change based on the state of the economy (expansion or recession) and the growth in fuel use.

For this exercise we’ll use refinery runs for the amount of crude oil consumed by the US economy. In reality we use some crude oil for other things, but not enough that it matters much.

Interestingly, refinery runs peaked in 1978 at about 15 million barrels per day (Mbpd) and then fell to just less than 12 Mbpd in 1983. Since then, production has slowly grown so that we’re at about 15.7 Mbpd today.

In looking at the data, we can use either real (inflation adjusted) prices or nominal (current) prices. Since we’re comparing oil expenditures to total GDP, it won’t matter as long as we’re consistent. Let's use nominal (current) prices and GDP.

Now for the data we need.

Since the price rose over a period of years, we’re going to need data for several years. For the first period we’ll use the 5 years 1978 through 1982. For the second period we’ll use 2004 through 2007 and estimate 2008. (2007 and 2008 data is provided in the example calculations below.)

For each year we’ll need the Crude Oil Refiner Acquisition Cost, the Gross Input to Distillation Units and Gross Domestic Product.

For the first number, click on the link above. US refineries use a combination of domestic and imported crude, so we'll want the composite number. The second number may be found at the Energy Information Administration web site www.eia.doe.gov Look for historical data overview, then Petroleum AER (Annual Energy Review), and finally Refinery Capacity and Utilization. For GDP numbers we can look at the FRED II database maintained by the St. Louis Federal Reserve Bank, also on the web at http://research.stlouisfed.org/fred2/ Alternately, look at the NIPA tables over at the Bureau of Economic Analysis web site.

1. For each year, calculate how much the US economy spent on crude oil as a percentage of GDP. Then have a look at the year to year change for each period, 1978-1982 and 2002-2007. (12 points)

Example - Spending on crude oil for 2007: 15,600 thousand barrels per day x 365 days per year x $70 per barrel = $399 billion
$399 billion / $13,841.0 billion = 2.88% of GDP for 2007

Example - Spending on crude oil for 2008: 15,300 thousand barrels per day x 365 days per year x $95 per barrel = $531 billion
$531 billion / $14,200 billion = 3.74% of GDP for 2008

Year to year change, 2007 to 2008 = 3.74% - 2.88% = 0.86%

Now do the same calculations for the years 1978-82 and 2004-2008. (Show me both your data and your calculations.)

2. Looking at the year to year change, what does this tell us about a potential supply shock from rising crude prices today? (7 points)

3. Looking at the percentage of GDP spent on crude oil, what does it tell us about the importance of crude oil to the economy today versus the earlier period? (6 points)

4. Any other thoughts or insights? (? points)

For a view of how the Federal Reserve looks at oil price shocks and what they can do about them, see:

Oil Shocks and Monetary Policy "Oil shocks have confounded macroeconomists since they first arose on the scene in the 1970s. The oil price spikes of that time clearly had significant macroeconomic implications..."

Just out of curiosity, I ran the numbers for the first oil price shock around 1973. You may want to organize your data in a similar table.

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