Streetwise Professor

October 14, 2014

The IEA Has Identification Issues: Econ 101 Fail

Filed under: Commodities,Economics,Energy — The Professor @ 1:39 pm

The IEA’s most recent report includes this gem of an analysis:

Recent price declines have sparked speculation about their potentially supportive impact on demand. The price elasticity of oil demand tends to be asymmetric in nature: oil demand falls on high prices more easily than it expands on lower prices. Looking at the last five incidences of crude oil price declines of 15% or more over a four‐month period (as occurred, at the time of going to press, June‐through‐ October), only in one case (in 2006) was a noticeable uptick in demand seen.

The immediate impact tends to be weakening demand reducing oil prices, as opposed to lower prices triggering additional deliveries, which is very much lagged. The dramatic price decline of late 2008/early 2009, for example, was not followed by a noticeable uptick in global oil demand growth until 2H09, many months after prices had started to rebound. Oil price changes will naturally affect demand differently depending on whether they are themselves supply‐ or demand‐driven. The price drop in 2008 was overwhelmingly demand led, whereas recent declines appear to have been largely in response to rising supply. Nevertheless, recent price movements are not expected to significantly lift demand in the short term, especially since crude price drops are not fully carried through to retail product prices.

That sound you just heard was me doing a I-coulda-had-a-V8 head slap.

Um, the IEA is making the most basic error possible: mistaking a fall in quantity demanded (consumed) for a fall in demand. A decline in demand (i.e., a movement in the demand curve) leads to a decline in price and quantity. This is exactly what happened in the episodes the IEA discusses: the 2008-2009 episode is the most severe example. Demand fell precipitously due to the financial crisis and subsequent Great Recession. This cratered prices, and also led to a decline in consumption.

Prices and consumption move inversely when there is a move along the demand curve. This occurs due to a supply shock.

This is Econ 101 textbook stuff, people. It has an name: identification. You can identify a demand curve only by holding it fixed and moving the supply curve. If the demand curve is moving around, you can’t identify a demand curve from price and quantity movements.

Hell, the IEA even recognizes this problem: look at the second paragraph. But if they recognize the problem in the second paragraph, why did they write the first paragraph? And this asymmetry in elasticity stuff? What, did the IEA have an acid flashback of a 60s textbook’s analysis of Sweezy’s Kinked Demand Curve?

I would seriously question whether the current price drop is totally supply driven as well. Chinese demand appears to have dropped steeply, and the European economy is slowing notably: Germany in particular has hit a rough patch.

So the IEA fails Econ 101, but we’re supposed to take seriously its analysis of more complex issues?

Print Friendly, PDF & Email


  1. Mere knowledge of the basics is not enough, or even important in these matters. When operating in the rarified atmosphere of international economics and policy making,particularly at conferences it is more necessary to hydromulatethe frumpus with a kleagle while impressively loading up on the Hors D’oeuvre plate and not spilling stuff on your HERMES tie.

    Let’s get with the program, folks.

    Comment by Sotos — October 15, 2014 @ 7:29 am

  2. Was about to get upset with you for not linking to the report, professor. A little googling shows you have to subscribe or wait for the public release. It is hard to understand how the IEA could make such a basic mistake and not have anyone catch it before release.

    Comment by Ben — October 15, 2014 @ 8:22 am

  3. @Ben-Glad I escaped a chastisement 😛 Yeah, IEA gates its reports. I cribbed what I quoted off FTAlphaville.

    I shook my head when I read it. Pitiful.

    The ProfessorComment by The Professor — October 15, 2014 @ 1:40 pm

RSS feed for comments on this post. TrackBack URI

Leave a comment

Powered by WordPress