Consumer Gasoline Prices: An Empirical Investigation: A Structural Vector Autoregression Model Indicates That Price Changes for Consumer Gasoline Have Been Driven by Changes in Supply Rather Than Changes in Demand

By Weinhagen, Jonathan | Monthly Labor Review, July 2003 | Go to article overview

Consumer Gasoline Prices: An Empirical Investigation: A Structural Vector Autoregression Model Indicates That Price Changes for Consumer Gasoline Have Been Driven by Changes in Supply Rather Than Changes in Demand


Weinhagen, Jonathan, Monthly Labor Review


According to the BLS Consumer Expenditure Survey, the average consumer spent approximately $1,300 on gasoline and motor oil in 2000, ma increase of 22.4 percent over the 1999 figure. Over the same period, the average price of gasoline increased 36.3 percent, (1) indicating that price changes within the gasoline market can substantially affect consumers' expenses. Conventional reasoning suggests that the high level of volatility for gasoline prices is the result of supply forces, as the price of crude petroleum changes rapidly due to production decisions of the Organization of Petroleum Exporting Countries (OPEC) nations. However, shifts in demand also can cause variations in gasoline prices. The purpose of this article is to examine the nature of price changes for consumer gasoline, using econometric techniques as well as historical evidence.

The second section of the article analyzes the impact of crude-oil supply shocks on prices at various stages of gasoline production by visually examining those price changes for crude oil, producer gasoline, and consumer gasoline which occurred subsequent to interruptions in the supply of crude petroleum. The major supply shocks considered ore the Yom Kippur War, the Iranian Revolution, the Iran-Iraq War, the Persian Gulf War, and a 1999 OPEC production cut.

The article's third section constructs a structural simultaneous-equations model of the market for consumer gasoline to determine the effects of changes in supply and demand on the price of gasoline. The model developed is a five-variable structural vector autoregression constructed from the Producer Price Indexes (PPI'S) for crude petroleum and gasoline, the Consumer Price Index (CPI) for gasoline, the quantity of gasoline consumed domestically, and the industrial production index. The final section of the article presents its conclusion.

Historical evidence

The impact of supply shocks on prices at various stages of processing within the gasoline market can be analyzed by visually examining historical price movements for crude petroleum, producer gasoline, and consumer gasoline. The actions of the OPEC cartel enable petroleum-based supply shocks to be easily identified and their effects on prices throughout the gasoline market to be examined. The analysis begins with a historical overview of OPEC.

OPEC's history. OPEC was established in September 1960 at the Baghdad Conference. Initially, the cartel included Iran, Iraq, Kuwait, Saudi Arabia, and Venezuela. By the end of 1971, Qatar, Indonesia, Libya, the United Arab Emirates, and Nigeria had joined the organization. From OPEC's inception until the early 1970s, the cartel was unable to exert any significant control over crude-petroleum prices. Prices for crude petroleum remained relatively stable in nominal terms at around $3.00 per barrel from 1958 to 1970 and fell in real terms over the same period. (2)

During the 1970s, OPEC's ability to influence crude-petroleum prices increased substantially due to rising demand for petroleum products (3) and the strength the organization gained from the addition of new members. OPEC's increasing power in the petroleum market becomes apparent from the effects its supply decisions have had on petroleum prices since the 1970s.

OPEC supply shocks. Chart 1 displays the PPI'S for crude petroleum and gasoline and the CPI for gasoline. For a simplified comparison, the three indexes were rebased to March 1973 = 100. The first major interruption in OPEC's petroleum supply resulted from an oil embargo launched in connection with the Yom Kippur War. As a result, U.S. imports of crude petroleum fell by approximately 30 percent while the embargo was in place. (4) The drastic reduction in the supply of crude petroleum caused domestic prices to rise 67 percent from October 1973 to the end of 1974. Over the same period, domestic prices for wholesale and consumer gasoline increased 67 and 32 percent, respectively, indicating a strong pass-through relationship between crude-petroleum prices and gasoline prices. …

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