Supply and Demand Shocks in the Oil Market: Theory Applied
51 Pages Posted: 27 Jul 2014 Last revised: 7 May 2016
Date Written: September 1, 2012
This paper contains a dynamic stochastic general equilibrium (DSGE) model comprised of a representative consumer, a firm, and an oil-sector with storage technology. The purpose is to test if the identification strategy and predictability results in Rapaport (2013a) are consistent with this rational setting. A simplified version of the model allows for structural recovery of theoretical counterparts to the reduced-form predictors in Rapaport (2013a) which are highly correlated and display the same prominent variability around oil-market-specific and economy-wide events. A full-blown version of the model motivates the identification strategy and predictability results in Rapaport (2013a) by qualitatively matching the sign of the impulse-responses of the relevant endogenous variables to several explicitly modeled shocks. The model quantitatively matches key asset pricing, macroeconomic, and oil-market-specific unconditional moments, but finds it hard to match the magnitude of excess returns predictability found in Rapaport (2013a). The paper finds that an unexpected and persistent increase in the conditional volatility of the oil supply shock, which leads to an oil price increase and stock market decrease, leads also to the observed increase in the ex-ante expected excess returns from betting short in oil futures and long in the stock market. Albeit, the magnitude of the increase in uncertainty regarding oil supplies that is needed to rationalize the empirical predictability is an order of magnitude larger than what is plausible and poses a puzzle.
Keywords: Oil, DSGE, Predictability, Risk Premium, Supply, Demand
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