Understanding Oil Price Dynamics and their Effects over Recent Decades: An Interview with James Hamilton.

• Author: Jawadi, Fredj

BACKGROUND AND INTRODUCTION

James D. (Jim) Hamilton has since 1992 been a professor in the Economics Department at the University of California at San Diego, where he currently holds the Robert F. Engle endowed chair in economics. He served as department chair from 1999-2002, and has also taught at Harvard University and the University of Virginia. He received a Ph.D. in economics from the University of California at Berkeley in 1983. Professor Hamilton has published on a wide range of topics. His research in areas that include econometrics, business cycles, monetary policy and energy markets has received more than 50,000 citations. His graduate textbook on time series analysis has sold over 50,000 copies and has been translated into Chinese, Japanese and Italian. He also contributes to Econbrowser, a popular economics blog. Academic honors include Research Associate with the National Bureau of Economic Research, Best Paper Award for 2010-2011 from the International Institute of Forecasters, and the 2014 award for Outstanding Contributions to the Profession from the International Association for Energy Economics. He is a Fellow of the Econometric Society and the Journal of Econometrics and a Founding Fellow of the International Association for Applied Econometrics. He has been a visiting scholar at the Federal Reserve Board in Washington, DC, as well as the Federal Reserve Banks of Atlanta, Boston, New York, Philadelphia, Richmond and San Francisco. He has also been a consultant to the National Academy of Sciences, the Commodity Futures Trading Commission and the European Central Bank, and has testified before the United States Congress. Professor Hamilton has received six teaching awards from the UCSD Economics Department.

The main focus of our interview is on James Hamilton's work in the field of Energy Economics. The aim is to improve our understanding of the drivers of oil price dynamics and their effects on the macroeconomy, both in the past, in the aftermath of the 2008 global financial crisis, and more recently in 2014. This is particularly relevant because Jim has been a leading voice in the field of energy economics since the 1980s. Jim was the plenary speaker at the 5th International Symposium in Computational Economics and Finance (Paris, April 12-14, 2018), and he was kind enough to agree to an interview on the evening of the symposium. We sent Jim the questions prior to our meeting.

We hope that this interview will provide you with further insights into the drivers and consequences of oil price shocks, while illustrating Jim's contribution to energy economics and energy markets.

The interview is organized into four sections. The first section presents the context and some general questions on the motivating factors in oil markets. The second section discusses the factors driving changes in oil prices. An analysis of the effects of oil price shocks on the economy is the focus of section three, while section four gives some insights into the future of oil price dynamics.

1. CONTEXT AND MOTIVATION

   Fredj: Q1. When and why did you decide to work on issues in the oil market?

   Jim: When I was a graduate student in the late 1970s, we were in a very turbulent period for energy markets. We'd seen the OPEC oil embargo of 1973/74 lead to a big increase in the price of oil and then a few years later, with the Iranian revolution in 1978/79, there was another big increase in oil prices, and it seemed that those events were contributing factors to some of the weak US economic performance of that decade. And as I looked into this, I was surprised to discover this wasn't the only time something like this had happened. In fact, of the seven recessions we'd had in the United States up to that point, six of them had been preceded by a very sharp increase in the price of oil and so I decided to work on that relation for my dissertation, and in fact by the time I was done, the count was up to seven out of eight. We had the Iran/Iraq war shortly after the Iranian revolution, and we had one of the shortest expansions in US economic history, we had the eighth US recession follow the seventh within twelve months.

   Fredj: Q2. How would you classify this area of your research?

   Jim: It's at the intersection between energy economics and macroeconomics and econometrics, and those are sometimes a little unusual combination for a lot of energy economists from a micro point of view.

   I was always interested in the macro question because that's part of what I saw going on in the 1970s.

   Fredj: Q3.Why should we be interested in this line of research on energy markets?

   Jim: One of the questions I got when I was pointing out this relation to people, was they said, "Well, how could this be? Oil is such a small share of total GDP, how could something that small in terms of the dollar value lead to these really big disruptions", and I think that's a very interesting question. I'm convinced that they did, and I'm convinced that that's related to a lot of our puzzles in macro, we seem to see small disturbances have big effects, there's something very inefficient it seems, there's something very disruptive going on in the economic recession.

   A lot of people attribute that to nominal rigidities. I think in fact technological rigidities are an important part of it.

   Fredj: Q4. Is the term "oil shock" a suitable one for describing large changes in oil prices? Why is the oil market so volatile?

   Jim: Commodity prices generally are volatile, and the reason for that is that the demand is relatively inelastic in the short run. I think that's particularly true in the case of oil. People can't do that much in the short run to change the amount of gasoline they consume this month, and you combine that with the fact that oil has often been subject to substantial disruptions in the supply. Geopolitical events would lead to perhaps a 5% reduction in the total quantity produced. Well 5% might not seem like that big an amount, but when you have that low elasticity in demand, it can lead to a doubling of the price of oil in a relatively short period. So yes, I think shocks is a good term for what these events often were. We've come to use 'shocks' for a general description of something in macro models. In this case, I think we have very clearly identified some historical events and know for sure that OPEC cut production by this amount and here's how much oil prices went up.

2. CAUSES AND DRIVERS OF OIL PRICE CHANGES

   Fredj: Q5. What are the main historical causes of postwar oil shocks? Are they purely specific to the oil market or are they linked to business cycle dynamics or other exogenous shocks?

   Jim: You can talk about different contributing factors in different episodes and in fact some people have rightfully pointed out, there were a number of things producing inflationary pressure, for example, in 1974 or '75. But on top of those, there were very specific events. In the fall of 1973, there was a very abrupt cut in the production of oil and a very abrupt increase in the price of oil and there are a number of events like that. I've mentioned the OPEC embargo, the Iranian revolution, the Iran/Iraq war are three of them, the Suez crisis in 1956/57 is another example like that, and the first Persian Gulf War in 1990/91. So those are five classic examples of oil shocks, where I think it's pretty clear that the major driver was exogenous geopolitical events which in fact were unique to the oil sector. So yes, there are a variety of things that could lead to a change in oil prices and that's something we sometimes see, but for some of these episodes I think there's a pretty clear understanding that it really was a shock, an exogenous shock to the economy that manifested in an abrupt increase in the price of oil.

   Fredj: Q6. Were the causes of the 2008-2009 oil shock different from previous ones? If so, why? What role did China play in the patterns of oil price changes since 2000?

   Jim: It's very different and that was something that interested me into looking more at what was going on in that episode because there really wasn't anything geopolitical in that case. It was part of a broad pattern in terms that commodity prices generally were strong, and I think that the common factor in that was the strong demand from emerging economies, particularly China. But what I think was a little special about oil was that you see kind of a break in the historical pattern of oil production in 2005 to 2008. Usually it had been going up year after year as we found new sources of oil. Well, it kind of stagnated for 3 years there from 2005 to 2008, world field production of crude oil, and that was the time when the demand for consumption from China was increasing quite a bit. Well how can you have China consuming more oil when no more oil is being produced? Well the only way is for the other countries, the United States, Europe and Japan, to decrease our consumption of oil. As I was saying, it takes a lot to persuade people in a short period of time to decrease their consumption of oil, and the result was a pretty dramatic increase in the price from the end of 2007 to the middle of 2008, which in terms of magnitude was nearly as big a movement in oil prices as these other episodes I was talking about, although it came from rather different causes, and I was interested to see that the general response of the US economy was not that different to the oil price increase in 2007/2008 compared to the earlier episodes.

   Fredj: Q7. In your paper "Understanding Crude Oil prices", published in 2009 in The Energy Journal (Vol. 30, No 2, 179-206), you mentioned the role of commodity speculation among other factors explaining oil price changes. How important is this phenomenon in explaining the run-up in oil prices between 2010 and 2013?

   Jim: Well, that was...