Elasticity of Demand for Relative Petroleum Inventory in the Short Run

By Ye, Michael; Zyren, John et al. | Atlantic Economic Journal, March 2003 | Go to article overview
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Elasticity of Demand for Relative Petroleum Inventory in the Short Run


Ye, Michael, Zyren, John, Shore, Joanne, Atlantic Economic Journal


Introduction

In this paper, the authors explored the importance of the deviation of inventories away from some expected or normal level in understanding petroleum markets. They refer to this deviation from normal as the relative inventory level. Since supply and demand for petroleum are less elastic to price in the short run than is inventory, it is this relative inventory level that plays the role of absorbing unexpected shifts in demand and supply. This observation stimulated exploring the price elasticity of demand for relative inventory levels theoretically and empirically. This paper describes why relative inventory level is an important variable to understanding petroleum markets and demonstrates theoretically that the demand for relative inventory must be negatively related to price. Then the paper estimates the short-run price elasticity of demand for relative inventories for several OECD countries and country groups and find it to be negative and statistically significant, supporting the theory they developed.

The petroleum market since the Gulf War exhibited several features that allowed the investigation of short-run petroleum market behavior in terms of supply, demand, and inventory. Over much of the time between 1991 and the present, the Organization of Petroleum Exporting Countries (OPEC) did relatively little to adjust production in order to accommodate consumption changes, and sometimes, when action was taken, it was either insufficient or excessive to stabilize prices. Thus, there was a fairly long period in which prices varied considerably. In particular, from 1996 to the present, prices exhibited large cyclical swings. As shown in Figure 1, monthly average West Texas Intermediate (WTI) crude oil spot price (nominal) dropped to nearly $11 per barrel early in 1999 and rose to a peak of nearly $35 per barrel towards the end of 2000.

The level of petroleum inventories also varied considerably during the 1990s. Figure 2 shows the combined government and industrial inventories of both crude oil and petroleum products in all Organization of Economic Cooperation and Development (OECD) countries. (2) Two things can be observed from the figure. First, there appeared to be a seasonal pattern in the early 1990s when the WTI prices were relatively stable. Second, since 1996, a negative relationship between petroleum inventory and crude oil price is evident when WTI prices experienced large swings. As the crude oil price dropped from 1996 to 1998, OECD total inventories climbed to record levels in 1998. Later, when the price climbed to its peak in late 2000, total inventories declined. Intuitively, the authors suspect that the relationship between inventory and price was masked by the seasonal pattern in the early 1990s and that the seasonal pattern was overwhelmed by the large price swings since 1996. Thus, further careful analysis of petroleum i nventory is needed to understand its relationship to WTI price.

The relationship between commodity inventory levels and spot prices has been theoretically as well as empirically studied for nearly a century. (3) There also have been many studies on petroleum demand and price elasticity of demand for crude oil and oil products in the mid to long run. (4) However, no previous studies on short-run price elasticity for petroleum inventory were available.

In this paper, the price elasticity of demand for petroleum inventory in the short run is investigated. A better understanding of the relationship between price and inventory was found by decomposing observed inventory movement into an expected component of normal seasonal movement and general trend and into an unexpected component that reflects responses to the short-run atypical variations in market supply and demand. This unexpected component is called the demand for relative inventory. The authors estimated the normal seasonal and trend components and relative inventory level for the Post Gulf War period from March 1991 to June 2001.

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