Economics 201 - Lawlor
Oil Prices – Real and Nominal
1. The nominal price of oil:
45
40
35
30
oilprice
25
20
15
10
5
0
1950 1960 1970 1980 1990 2000
The nominal price of oil has varied quite substantially in the post-war era. Before the
early seventies the price was kept very low by western companies’ control of Middle
Eastern oil supplies. With the nationalization of these reserves in Saudi Arabia, Iran, Iraq
and the Gulf States, and the formation of OPEC to control the supply of its countries’ oil
reserves to the world market, the price went up. This is seen in the nineteen seventies,
particularly in the periods of the 73-34 oil embargo associated with the Israeli Yom
Kippur War, and in 78-80 during the Iranian revolution and hostage crisis.
Since then, the nominal price of oil has been more stable, moving within the range of 20
to 25 dollars a barrel for most of the 80 and 90’s. Amongst oil market analysts this was
largely seen as a Saudi Arabia decision based on a combination of factors. One was to
impose order in the market, so as not to injure the very western economies upon which
OPEC wealth depends and to not tempt the west with too high an oil price to get serious
again about conservation and alternative energy sources, as they had begun to do in the
seventies. Two, because a cartel is always prone to cheating, this price drop was partly to
punish small members of OPEC for straying from production quotas. Saudi Arabia’s
large weight in total world reserves and its ability to, at will, flood the market was
responsible for its power in this regard. It is also the case that OPEC control of world oil
in the eighties and nineties was weakened by non-OPEC production in the North Sea,
Africa and Latin America. As these resources have dwindled and as Russian production
has not yet proven reliable, the market power of Saudi Arabia and OPEC has grown.
More recently, we have seen the growing world appetite for oil augmented by the
development of India and, especially, China. There have also been recent supply
influences from lagging and disrupted Iraqi oil and the general insecurity in the Middle
Eastern region as a whole. The net result right now is a rising price of oil, in nominal
terms. The future, given the expected continued trend rise in Indian and Chinese demand
and the supply-driven growing power of the Middle East, can only be seen through a
glass darkly. But, no doubt now more than ever, oil has become a security issue with the
mess that exists in that region today.
2. The CPI.
200
180
160
140
cpiaucsl
120
100
80
60
40
20
1950 1960 1970 1980 1990 2000
During the same period there has been a constant rise in the price level, as measured here
by the CPI. Its rate of change, though always positive, has varied over shorter periods. It
was highest in the seventies. This was at least partly due to the very sharp increases in the
nominal price of oil we saw above. For instance, the annual inflation rate measured as the
percentage change in the CPI is as follows.
0.16
0.14
0.12
0.1
0.08
cpchg
0.06
0.04
0.02
0
-0.02
-0.04
1950 1960 1970 1980 1990 2000
3. The real price of
oil.
50
45
40
35
realoilp
30
25
20
15
10
5
1950 1960 1970 1980 1990 2000
Thus the real price of oil, deflated to adjust to 1982-84 dollars, looks very different than
the nominal price. After the soaring real price increases of the seventies and early
eighties, the real price of oil settled down to a low, pre-73, level. It did not keep up with
inflation in the nineties and, despite its recent rise, it is still at pre-seventies levels in real
terms.
Thus the two series, the nominal and real price of oil, look like:
50
oilprice
45 realoilp
40
35
30
25
20
15
10
5
0
1950 1960 1970 1980 1990 2000
4. Practical Details
This may be review for some of you, but a few have asked me to demonstrate for the
record the method of arriving at real, inflation adjusted, deflated values.
For the nominal price of oil I used the price of west Texas intermediate crude per barrel,
reported in monthly observations back to 1946, from the St. Louis Federal Reserve data
base, (available on the Economics Dept. server through GRETL as are all the variables
and commands reported here). It is defined there as “oil price.”
For the price level I used the consumer price index for all urban consumers, total, base
year normalized to equal 100 from the average of 1982-84 prices. It is defined as
“cpiaucsl.”
Most price indices, this one included, are reported multiplied by 100, as in:
(Prices of a basket of consumer goods in current year)/ (Prices of a basket of consumer
goods in the base year) * 100
So we need to divide the index by 100 to put it back in a form to deflate other nominal
values.
Thus the real price of oil is defined as:
realoilp = oilprice/(cpiaucsl/100)
If we want to measure the inflation rate, defined above as annualra, we have to compute
the annual percentage change in cpiausc1. This is reported monthly so we will have to lag
the difference, as in
Annual % rate of change = (CPI(current) - CPI(12 months ago))/CPI(12 months ago)
The annual rate of change in the CPI is defined as “annualra.”
For later use, when you are comfortable with GRETL, I append the script of a simple data
program to do this.
Type of data: time series
Frequency: monthly
Range: 1946:01 - 2004:08 (n = 704)
Listing of variables:
oilprice Oil Price Domestic: West Texas Intermediate; $/Barrel
cpiaucsl Consumer Price Index All Urban Consumers: Total; 1982-84=100 SA
realoilp (oilprice)/(cpiaucsl/100)
annualra (cpiaucsl-cpiaucsl(-12))/(cpiaucsl(-12)
Update: 1-24-06
Given the recent rise in oil prices, the students in 201/2006/1 st half-of-semester prompted
me to update the above chart for the recent run up in oil prices. That chart looks as
follows:
70
oilprice
realoilp
60
50
40
30
20
10
0
1950 1960 1970 1980 1990 2000