Class Project
The Determination of the Demand for
Crude Oil in the US
Applied Econometrics
Presented by
Milana Borisev
May 11, 2007, 2007
ABSTRACT
Crude oil has proven to be an extremely versatile substance, in light of the variety of
products that are derived from its extraction and refining. The most notable and desirable
of these products is gasoline or petrol which is demanded by all industrialized nations
including the United States. This research paper examines the factors which determine
the level of demand for crude oil in the United States, and ultimately derives the US
demand function for crude oil, utilizing statistical methods, and data sets from the period
1986 to 2004.
1. Statement of the problem.
Crude oil products play a critical role in industry; producing energy to propel
vehicles, power turbines and heat factory facilities. In addition, crude oil by- products
form the basis of the petrochemical industry in which plastics are manufactured.
The versatility of crude oil has led to its consumption in a variety of sectors and
demand is often categorized and analyzed according to each sector. These sectors
include:
 Transportation Sector: For use in cars, trucks, buses, trains and airplanes
 Non-Transportation Sector : Manufacturing, Residential and Service
The consumption of crude oil has grown significantly over the past decade. Since
1995 world oil consumption increased from 70.0 to 82.4 million barrels per day (bpd).1
While many attribute this dramatic increase in demand to increased economic activity in
China and India, increased crude oil demand has originated from both Organization of
Economic Developing Countries (OECD) and Non-OECD countries. OECD countries oil
use from 1995 through 2004 rose almost 5 million bpd while Non-OECD use grew more
quickly, expanding by 7.7 million bpd. China represented only 39% of this non-OECD
growth. 2This is an interesting question to study because crude oil and its consumption, as
I mentioned in previous paragraph, play very important role in variety of sectors. The
reason that really motivated me to this research is that I wanted to estimate what effect
price change has on demand for crude oil.
The United States has also seen an increase in consumption between 2003 and 2004
from 20 million to 20.4 million with the largest consumption being attributed to gasoline
within transportation sector. This leads to the purpose of this research paper which is to
derive the demand function for crude oil in the United States.
United States is one of the most developed countries in the world where
consumption of crude oil and its products fall in the group of necessities. Under this
assumption I will test to see what factors derives the US demand function for crude oil,
utilizing statistical methods, and data sets from the period 1986 to 2004.
1
2
Energy Information Administration: This week in petroleum 1998.
Energy Information Administration; International Energy Outlook 2006.
2
Review of Literature
Crude oil is one of the most important sources of energy and also represents about
41% of primary energy consumption worldwide. Crude oil is also used as raw material
for the photochemical industry all over the world. Since 1971 world crude oil
consumption increased for around 46 percent, and of this total United States of America
currently consumes just 25 percent. Also, over the 30 year, from 1971-2001, world crude
oil consumption increased by 46%. One of the things that caused this high percentage
increase in demand for oil and also strong incentive for the more efficient use of oil, are
new improvements in technology and also world wide developments. The average annual
rate of growth of oil consumption according to Cooper’s results (2003) has grown at the
slower rate than the real GDP, which means that the rate of oil consumption in the
production of GDP has declined. Cooper used econometric estimates to determine the
price elasticity in short and long term. The results that he came up with are saying that the
price elasticity is very low in both the long and the short run. The long run price
elasticities of demand for the United States is at -0.56, while the short –run price
elasticity was estimated at -0.08.From the results of the Coopers paper we can conclude
that in the short-run demand for the crude oil is highly price inelastic, and on the other
hand demand for the crude oil in a long-run is somewhat less price inelastic.
A Paper written by Castello (2006) is estimating whether changes in prices of
petroleum and (crude oil, motor gasoline), affect the demand for petroleum. One other
thing that he is estimating is short term demand elasticity’s relative to price changes. The
results that he came up with are that in short-term petroleum elasticity’s with respect to
price are small (demand is inelastic), and a reason for this is limited substitution
possibilities in the short term. Domestic petroleum consumption is expected to decline or
increase by about 0.4 percent for every permanent increase or decrease the price. 3 Both
of the papers written by Cooper( 2003) and Castello( 2006) are getting the same results
about demand elasticity’s relative to price changes.
The effect of changes in price and income level on oil demand is well explained in
the model estimated by Gately and Huntington (2001). They examine the asymmetric
effects on demand of decreases and increase in income and price levels and also the
different speeds of demand adjustments to changes in price and income. The results that
they came up with include the 96 world’s largest countries but they also estimated the
separate results for the US. The demand for the crude oil responds much more to
increases in oil prices than to decreases and the speed of demand which lead us to
asymmetric price response which is graphed on figure 1.4 The demand reduction in 1971
and 1973 was caused with the high oil price increase were not reversed by the oil price
3
Dave Costello , May 9,2006. Reduced Form Energy Model Elasticities from EIA’s Regional Short –Term
Energy Model (RSTM)
Figure 1 Source: Dermont Gately and Hillard G. Huntington, August 2001: “The Asymmetric Effects of
Changes in Price and Income on Energy and Oil Demand” ,page 5.
4
3
decrease in 1981-1986.As we could see from the figure1 that the demand responses to
increase in prices are not reversed when prices fall. Also one other result that they came
up with is that the demand effects of changes in income are not always perfectly
reversible which we could also see from the price changes responds of demand. US
average annual income growth rate is around 2% and oil demand growth rate is about
1%, which is showing that demand growth rate is lower that the growth rate in income.
Crude oil demand, according to Gately and Huntington (2001), has responded more to
increases in income than to decreases in income. The bottom line of this paper is that
demand has responded more to increases in income than to decreases in income level and
price, and also that even if there is increase in income level there could still be decrease
in demand for crude oil caused by increase in price of crude oil.
From the previous two papers we could see that the demand for the crude oil is
mostly determined by the price and income levels. I would like to review the paper that is
estimating the relationship between the price of crude oil and the real GDP levels (Guo,
Kliesen, 2005). As we could see from previous papers, there were large price movements
in crude oil since the World War II. One of the explanations is that oil price increases
cause GDP growth to decrease by raising production costs. Oil price volatility has a
negative and marginal effect on future GDP growth when combined with oil price
changes5.
5
Hui Guo and Kevin L. Kliesen, November/December 2005; Federal Reserve Bank of St. Louis Review:
“Oil Price Volatility and US Macroeconomic Activity”.
4
Figure 1
Figure 1 Source: Dermont Gately and Hillard G. Huntington, August 2001: “The Asymmetric Effects of
Changes in Price and Income on Energy and Oil Demand” ,page 5.
2. Formulation of the Model
A demand function can be described as how much of a good will be purchased at
alternative prices of that good and related goods, alternative income levels and alternative
values of other variables affecting demand.
5
This paper derives a linear demand function for crude oil in the US, which will take
a form similar to the equation below:
Consumption = β0 + β1 price + β2 rgdp+ β3 avmicars + β4 avmibuss + ei
The dependent variable: annual consumption of crude oil (thousand barrels per day)
Theoretical justification of right hand side regressors:
β1: average annual crude oil price (2003 constant dollars per barrel)
(Inverse relationship with dependent variable- as price increase, demand
decrease)
β2: real GDP per capita in actual 2003 dollars
(Direct relationship with dependent variable-higher real income level,
purchasing power increase)
β3: Average annual miles per vehicle- cars (1,000)
(Directly proportional with dependent variable- as average annual miles per
vehicle increase so does the demand for oil)
β4: Public Transportation miles of travel –busses (billions)
(Negative effect on dependent variable because as public transportation
increase there would be less demand for oil for end use)
Regression analysis would be used to derive a function similar to the above for the
US consumption of crude oil. Monthly data 1986-2004
3. Data Sources and Description
Variable name
Demand
Price
GDP
Car use
Bus_use
Variable description
Monthly consumption of crude oil (thousand barrels per
day)
Monthly spot crude oil prices( 2003 constants dollars
per barrel)
National quarterly real GDP per capita
Average annual miles per vehicle- cars (1,000)
Annual Public Transportation miles of travel –busses
(billions)
Data Source
(1)
(2)
(3)
(4)
(5)
6
Data Source:
(1) Energy Information Administration. March 2007 Monthly Energy Review.
Table 11.2. Petroleum Consumption in OECD Countries. Web page:
http://tonto.eia.doe.gov/merquery/mer_data.asp?table=T11.02
(2) U.S. Department of Energy, Energy Information Administration. Web page:
http://tonto.eia.doe.gov/dnav/pet/xls/pet_pri_spt_s1_m.xls#'1-Crude%20Oil'!A1
(3) U.S. Bureau of Economic Analyses. Quarterly national GDP level .Web page:
http://www.bea.gov/national/xls/gdplev.xls
(4) US Census Bureau- 2007 Statistical Abstract. Table 1080. Motor Vehicle
Distance Traveled by Type of Vehicle: 1970 to 2004
(5) US Census Bureau- 2007 Statistical Abstract. Table 1080. Motor Vehicle
Distance Traveled by Type of Vehicle: 1970 to 2004
4. Results
I used SAS program to conduct empirical analyses. Time series data set is used in
estimation. Time series data set consists of weekly observation for US over the 19861994 periods. Missing values for some variables in the model yielded a data set with 276
observations in total.
Results of utilizing statistical regression analysis are showing that demand for crude
oil is relatively price inelastic in a long run. There is a positive relationship between price
of crude oil and demand for crude oil, as price increases by $1 there is an increase of 610
barrels of oil per day. Also, the results are showing that there is a positive relationship
between the real GDP level and consumption of oil. If real GDP per capita goes up by
one, there is an increase in consumption of 618 barrels per day. Average car miles and
consumption of crude oil are directly related. More car miles traveled by car more oil will
be demanded. Numerically stated, when the average annual miles per vehicle increase by
1,000, there is also an increase in consumption of crude oil for 3668 barrels per day.
Also, the relationship between consumption of crude oil and public transportation miles
of travel is positive. Increase in public transportation miles causes consumption for crude
oil also to increase.
Most of the regression results are same as I predicted them to be, except the public
transportation miles of travel.
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5. Conclusion
This paper uses a weekly data set to examine the effect of crude oil price changes
on consumption of crude oil. From the regression analyses we can conclude that as
real income per capita increases, the quantity demanded of crude oil also increase.
Similarly, an increase in the price of oil causes also increases in the quantity
demanded of oil. This is true, as any increase in oil price is usually interpreted as
meaning that oil prices are on the rise so buyers increase how much they purchase to
stock up or create the reserves. From this perspective it is clear to see why there exist
positive relationship between the quantity demanded and the price, since oil since oil
can be considered a necessity to a large extent.
The results are consistent with the results of Cooper’s (2003) paper and
Castello’s (2006) paper. In long-run crude oil elasticity’s with respect to price are
small .One of the reasons is that there is a limited number of substitutes for crude oil
and petroleum.
Table 1: Results of regression- factors that affect US consumption of crude oil (Dep.Var.
= demand for 1,000 barrels per day).
Regressors
Model one
Constant
7209.811***
( 1199.897)
0.61024
(6.344)
0.61835***
( 0.11828)
3.66808**
(1.311)
47.68249
(61.07727)
Price
GDP
Car use
Bus use
Rsquare
Root MSE
No.observations
Mean
Std.Dev.
18233.67
1386.33
22.1996
7.0428
8302.26
1383.74
1481.96
123.603
9.24
0.591
0.8993
443.89359
276
Notes: *** statistically significant at one percent level;-**five percent level
8
Reference page:
-
Energy Information Administration: This week in petroleum 1998.
-
Energy Information Administration; International Energy Outlook 2006
-
Dave Costello , May 9,2006. Reduced Form Energy Model Elasticities from
EIA’s Regional Short –Term Energy Model (RSTM)
-
Dermont Gately and Hillard G. Huntington, August 2001: “The Asymmetric
Effects of Changes in Price and Income on Energy and Oil Demand” ,page 5.
-
Hui Guo and Kevin L. Kliesen, November/December 2005; Federal Reserve Bank
of St. Louis Review: “Oil Price Volatility and US Macroeconomic Activity”.
9