from Energy, Security, and Climate and Energy Security and Climate Change Program

Why Are Oil Prices So Volatile?

January 12, 2011

Blog Post

More on:

Fossil Fuels

Oil prices are up again today. What’s going on? A look at history gives some interesting insights.

Eyal Dvir (Boston College) and Ken Rogoff (Harvard) have a very interesting working paper that tries to explain some important features of oil prices since 1861. Jim Hamilton has a neat discussion, over at Econbrowser, of the forces behind one particularly interesting episode, which he calls  “the first oil shock.” Starting from $11.65 (in 2009 dollars) in 1861, the price of oil in the United States skyrocketed to a peak of $110.11 by 1864, before dropping back to $36.84 in 1867. The whopping 845% spike in the oil price dwarfs anything seen since.

The interesting question, here, regards the source of the shock – and, in particular, whether there are any parallels to today. Hamilton argues that it was about technological limits to supply combined with idiosyncratic shifts in demand:

“Edwin Drake had drilled the first commercially successful oil well in Pennsylvania in 1859…. But it turned out that in each new well, the flow rate dropped fairly quickly as oil was removed, and the drillers also had difficulty figuring out how to prevent water flooding. After an initial phenomenal rate of success, total production from all wells in Pennsylvania declined in 1863 and fell further in 1864…. At the same time, the demand schedule was shifting to the right, due to war spending and most importantly a new tax on alcohol (a competitive source of illuminants) of $2/gallon, which gave a $40/barrel competitive advantage to crude. The result was that the real price of oil quintupled by 1864.”

Dvir and Rogoff, while not focusing as narrowly in time, argue that high oil price volatility in the period from 1861 to 1878 can be explained by much broader structural factors. The supply side, they argue, was artificially constrained due to a monopoly by railways on the transport of oil (broken only by the Tidewater pipeline in 1879). At the same time, the demand side was steadily climbing due to the rapid industrialization of the United States. Volatility in this period – there were spikes again in 1871 and 1876 – was due to these deeper drivers.

Both analyses draw parallels to today. Hamilton observes that the spike was relieved when people started to find oil in new places. He argues that this – not technological progress – is the real history of oil supply, and warns that today, there aren’t many new places to find oil. Dvir and Rogoff, for their part, observe a parallel between U.S. and East Asian industrialization (beginning in the mid to late 19th and 20th centuries respectively) on the demand side. On the supply side, OPEC replaces the rail monopoly in constraining supply and driving up both prices and volatility. This structural situation, they warn, tends to produce high volatility, and isn’t going away any time soon.

Who’s right? It’s quite possible that they both are. Strong growth in oil demand driven by economy-wide factors, combined with supply that is relatively unresponsive because of market structure, can amplify the broader consequences of what would otherwise be largely benign events in the oil markets. That looks like it was the case in the 1860s. The same appears to be true today.

More on:

Fossil Fuels