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Oil Prices, the IEA, and the Long-Term Effects of Oil Shocks

Today, the International Energy Agency (IEA) announced that, because of disruptions in the oil supply caused by the war in Libya, it will release 60 million barrels of oil from emergency reserves. The move drew harsh criticism from OPEC, which warned that a sudden increase in the supply of oil would lower prices to a level harmful to oil producers. The IEA decided to overlook those concerns because, as Executive Director Nobuo Tanaka said, “The global economy is still emerging from recession and it is essential that this recovery not be endangered by an oil supply shortage.” But are the IEA’s worries about the economic risks of an oil supply shortage justified?

According to a 2006 paper by the University of Michigan’s Lutz Kilian, the IEA might not need to worry so much–at least not where the U.S. is concerned. Though they can ruffle markets during acute moments of political upheaval, in the long run, oil shocks seem to have limited effects on America’s major macroeconomic indicators, such as GDP growth and Consumer Price Index (CPI) inflation. Kilian examined changes in those indicators in the U.S. after major exogenous oil shocks, such as the Iranian Revolution and the Iran-Iraq War. Though he found “statistically significant evidence of a sharp drop in real GDP growth five quarters after an exogenous oil supply shock and of a spike in CPI inflation three quarters after the shock,” Kilian nonetheless writes that his data “show that the effects of exogenous oil supply shocks on U.S. real GDP growth and CPI inflation were comparatively small on average.” In fact, Kilian constructed a number of historical counterfactuals by examining countries’ average oil production in the month before major upheavals, and then extrapolating what their production would have been if they had experienced the production growth rate and economic conditions of other countries that didn’t go through the same upheaval. Kilian’s counterfactual analysis “suggests that exogenous oil supply shocks made remarkably little difference overall for the evolution of U.S. real GDP growth and CPI inflation since the 1970s.”

So, while the IEA may be exercising special caution to avoid short-term pain, there doesn’t seem to be any reason to worry that turmoil in Middle East upheaval–and any oil shocks that result–will have long-term ramifications.