Oil shocks occur due to cyclical changes in the supply and demand drivers of the market. The four demand factors we use in our model are the 1) price return of copper, 2) value of the U.S. dollar relative to a basket of other currencies (DXY Index), 3) yield of the 10-year U.S. Treasury bond, and 4) slope of the oil futures term structure as specified by the two nearest-to-maturity contracts.
Copper’s return is a proxy for global growth, and therefore global demand, and thus captures the pace of global expansion. Because oil is priced globally in U.S. dollars, changes in the dollar’s strength affect the underlying price of the commodity for market participants whose preferred currency is not the dollar, such that the underlying economic value of the commodity remains unchanged. The 10-year U.S. Treasury yield is a proxy for the global risk appetite of investors; a lower yield suggests a lower risk appetite, leading to slower global growth and consumption. Finally, the slope of the oil futures term structure is a proxy for the estimated demand in the next period.
We use two supply variables: 1) U.S. oil production reported by the EIA and 2) monthly OPEC production reported by Bloomberg. These two factors are good examples of the types of variables that are masked if we analyze the return of oil as a whole, but become visible when we focus specifically on cyclical shocks.
The intuition is that shocks to these variables should drive shocks to oil prices around the otherwise slower-moving trend. Therefore, following the same process we use for oil, we can isolate the shocks from trend for each of the explanatory variables:
Oil Shockt = Term Structure Slopet + Copper Shockt + USD Shockt
+ 10YR Treasury Shockt + US Oil Production Shockt + OPEC Production Shockt
The only exception is for the slope of the futures term structure for which we use the simple difference between the prices of the second and first contracts.
In adding the variables to the model, we have expectations about the sign of each. The signs of copper and the 10-Year U.S. Treasury bond are expected to be positive (and they are), which indicate times of higher global growth and of lower risk appetite, respectively. The signs of the U.S. dollar and U.S. oil production are expected to be negative (and they are), because a strengthening dollar should reduce demand for oil, and unexpected increases in U.S. production should provide greater supply for a given level of demand. The sign of the term-structure slope is also expected to be negative (and it is), because a positive slope indicates a term structure in contango, the situation in which spot prices are lower than prices of futures contracts, creating a negative roll return. Following are the coefficients from modeling oil shocks with the supply and demand factor shocks: