Supply Shocks and Price Adjustment in the World Oil Market

Author(s): R. Glenn Hubbard

Source: The Quarterly Journal of Economics, Vol. 101, No. 1 (Feb., 1986), pp. 85-102
Published by: Oxford University Press
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 SUPPLY SHOCKS AND PRICE ADJUSTMENT IN THE
WORLDOIL MARKET*
R. GLENN HUBBARD

Understandingthe impacts of transitory oil supply shocks on world oil prices

is crucial to the evaluation of the economic impacts of shocks and the design of
policy responses to address those impacts. This paper integrates short-run and
long-run approachesto oil price determination, with particular emphasis on the
"two-price"structure of the world oil market-with coexisting short-term "spot"
pricesand long-term"contract"prices.Even transitoryshocks are shownto exhibit
persistence effects on long-termprices. Some implications for econometricmodels
of the relationship between spot and contract prices are discussed.

I. INTRODUCTION

Because of the macroeconomic costs of oil supply shocks,

movements in world oil prices have received considerable atten-
tion from policymakers.1 Economic and policy debates have fo-
cused on whether government policy intervention-in the form
of tariffs, price controls, public stockpiling of oil, etc.-can miti-
gate either the likelihood of the occurrenceof an oil shock or the
economiccosts associated with shocks (see, for example, Chao and
Manne [1982] and Gilbert and Mork [1982]). Understanding the
impacts of transitory shocks-"oil supply disruptions"-on prices
is crucial to the evaluation of the economic impacts of the shocks
and the design of policy responses to address those impacts.
Empirical efforts at modeling the world oil market have gen-
erally focused on either the very long run or the very short run.
Intertemporal models are useful for analyzing price determina-
tion in long-run equilibrium and can be explicitly derived from
optimizing behavior (as, for example, in Pindyck [1978] or Salant
[1982]). Those models may not, however, be relevant for describ-
ing the responses of prices immediately following an oil supply
shock.2Short-term models generally are not based on underlying

*I am grateful to RobertGordon,Kenneth Judd, RobertWeiner, and to anon-

ymous referees of this Journal for helpful comments and suggestions. Financial
supportfrom the National Science Foundation (SES-8408805)is acknowledged.
1. See the comparisonof the results of large-scale econometricmodels by the
StanfordUniversity Energy Modeling Forum [Hickman and Huntington, 1984].
2. The StanfordUniversity Energy ModelingForumstudy [1982] of the world
oil market, which comparedthe price predictions of some medium-run to long-
run optimizing models, certainly found this problem. See also the discussion in
Gately [1984].

?) 1986by the Presidentand Fellowsof HarvardCollege. Publishedby John Wiley & Sons,Inc.
The Quarterly Journal ofEconomics, February 1986 CCC 0033-5533/86/010085-18$04.00
86 QUARTERLYJOURNAL OF ECONOMICS

economictheory but on certain pricing rules. The use of capacity

utilization (usually with reference to OPEC) is common to most
of the rules.3 Despite their theoretical ambiguities, the use of
pricing rules may be appropriate in the short run because of
limited ability to change capacity.
This paper integrates the short-run and long-run approaches,
with particular emphasis on the simultaneous determination of
short-term "spot" prices and long-term "contract"prices.4 The
interest here is not so much on the origin of such a.multiple-price
system, but on its implications for the implications of shocks on
prices. Multiple-price systems are common in commodity mar-
kets, with "two-price"episodes in copper,5aluminum, nickel, van-
adium, and molybdenum. In addition, exploration of such ar-
rangements may providemacroeconomicfoundations of aggregate
models of price flexibility.6
The world oil market during the 1970s provided the most
dramatic example of the "two-price"phenomenon. Analyzing the
impact of the two-price system on the adjustment of oil prices in
response to market fluctuations is central to any discussion of
potential policy intervention. Analytical work has been scarce,
however. Two recent papers by Verleger [1982] and Bohi [1983]
have taken opposite points of view. The former held that the spot
market drove the whole pricing system because the spot price was
the marginal price, and the latter maintained that spot prices
were largely irrelevant.
Throughout the supply shocks of the 1970s and early 1980s,
the overwhelming majority of world oil trade took place through
term contracts,with a very small spot trade, the principal purpose
of which was to balance short-term shortages and surpluses of
individual oil companies and refiners. The oil market of the mid-

3. See, for example, Gately, Kyle, and Fischer [1977]; Nordhaus [1980]; and
Hubbardand Weiner [1983]. Sometimes these pricing rules have taken the form
of a reduced-form"price-reactionfunction."
4. In the oil market, "spot"refers to trades of single cargoes of crude oil or
petroleumproducts,while the "contract"market refers to ongoing sales at posted
prices. Until recently, spot market volume was low, and the general purpose of
transactions was to balance short-term shortages and surpluses of individual oil
companiesand refiners.
5. See the papers by Fisher, Cootner,and Baily [1972]; McNicol [1975]; and
Mackinnonand Olewiler [1980].
6. In his review of findings on this issue, Gordon[1981] highlights the need
to consider whether price inflexibility can be derived from optimizing behavior.
Taking a different approachfrom the "contracting"approachin this paper, Blan-
chard [1982] emphasizes the importance of the asynchronization of individual
price decisions for aggregate price rigidity.
 SUPPLY AND PRICE IN THE WORLDOIL MARKET 87

1980s, however, is more accurately characterized as being dom-

inated by spot market transactions and contracts of much shorter
duration than in the past. Both the volatility of world oil prices
in response to supply shocks and the effectiveness of such sug-
gested policy responses to supply disruptions as oil import tariffs
and releases of oil from public strategic stockpiles depend on the
extent of term contracting and, hence, degree of price flexibility
in the market.
This paper focuses on the impact of contracting on oil price ad-
justment to demand and supply fluctuations, and is organized as
follows. Section II describes the dynamic responses of spot and con-
tract prices to transitorydemandand supply shocks.The two prices
are jointly determined.Oil supply shocks affect both prices, though
the responses of each are different;even transitory shocks may ex-
hibit "persistenceeffects"on prices.Thoseresponsesdependon, inter
alia, the price responsiveness of demand, the share of total trades
carriedout on the spot market, and the speed of adjustment of con-
tract prices to new information. Section III discusses some impli-
cations for econometricmodeling of the relationship between spot
and contractprices in the market. Conclusions and suggestions for
future research are presented in Section IV.

II. RELATIONSHIPSAMONG PRICES IN THE WORLD OIL MARKET

The design of a model of price determination in the world oil
market must incorporatethe determinants of supply and demand,
with emphasis on the different types of "contracts"(and "contract
prices")prevailing and on the transmission of demand and supply
shocks. For simplicity, we consider only two types of contractual
arrangements: a "contract"market, in which oil is bought and
sold on the basis of predetermined prices; and a "spot"market,
in which the price at any point in time just equilibrates supply
and demand in the market. How such contractual arrangements
might have arisen is a different question and is not discussed
here. Transactions costs might serve as the basis for a willingness
to enter into contracts (see Wiliamson [1975] for a discussion of
this idea). Contracts may also be useful for their informational
content about long-term demand.
That the oil market is subject to periodic "shocks,"during
which the prices of crudeoil tradedon the spot market and through
long-term contracts can differ (sometimes by a wide margin and
in either direction) is obvious from an examination of Table I,
88 QUARTERLYJOURNAL OF ECONOMICS

TABLE I
CRUDE OIL SPOT AND CONTRACTPRICES (1973-1984)

Spot price Contract price

1973: 1 2.08 2.10

2 2.35 2.25
3 2.70 2.55
4 4.10 3.65
1974: 1 13.00 8.65
2 10.60 9.60
3 10.00 9.60
4 10.30 10.40
1975: 1 10.42 10.46
2 10.42 10.46
3 10.43 10.46
4 10.46 10.46
1976: 1 11.51 11.51
2 11.51 11.51
3 11.60 11.51
4 11.90 11.51
1977: 1 12.50 12.09
2 12.45 12.09
3 12.63 12.70
4 12.68 12.70
1978: 1 12.66 12.70
2 12.70 12.70
3 12.79 12.70
4 13.50 12.70
1979: 1 18.35 13.48
2 27.35 16.15
3 32.90 18.89
4 38.17 22.84
1980: 1 36.58 27.17
2 35.52 28.82
3 33.30 30.21
4 38.62 31.33
1981: 1 37.75 32.50
2 33.59 33.00
3 32.05 33.69
4 33.68 34.10
1982: 1 31.00 33.80
2 32.29 33.43
3 31.98 33.57
4 31.75 33.23
1983: 1 29.05 30.58
2 28.65 28.75
3 28.83 28.75
4 28.38 28.75
 SUPPLY AND PRICE IN THE WORLDOILMARKET 89

TABLE I
(Continued)

Spot price Contract price

1984: 1 28.56 28.75

2 28.31 28.75
3 27.66 28.75
4 27.81 28.74

Source.PetroleumIntelligenceWeekly[variousissues]. Data on spot and contractpricesreferto Mideast

Light-34crudeoil.

which presents representative quarterly time series of "spot"and

contract"(official government selling) prices for crude oil over
the periodfrom 1973 to 1984. That spot and contractprices diverge
only in response to demand or supply shocks suggests risk aver-
sion on the part of one or both parties [Carlton, 1979; Roberts,
1980] or uncertainty about market structure [Carlton,1978]. With
respect to the latter, supply and demand shifts are difficult to
distinguish in the short run, and the behavior of spot and contract
prices can provide information to market participants.
Below, we discuss the dynamic response of oil shocks to tran-
sitory shocks. In the absence of contracts or storage, there would
be no reason to expect intertemporal price correlation unless the
shocks were themselves serially correlated. The existence of long-
term contractsimplies, however, that the persistence of transitory
supply fluctuations depends on the ability of contract provisions
to adjust to market conditions. Shifts either in the term structure
of contracts or in the mix of spot and contract trades can alter
the short-run and long-run impacts of shocks on prices.
We introducethe two-price system into the model by allowing
in equilibrium a fraction axof world trade to be accomplished
through long-term contracts with producers.7The remaining por-
tion is traded on the spot market. A contract is defined as an
ongoing agreement to purchase oil at a given price. Uncertainty
arises, in that the system is subject to demand shocks (EDt) and
supply shocks (est), which are assumed to be independently and
identically distributed with mean zero and variances uD and Su,

7. That is, the model of spot and contract price adjustment describedbelow
can be viewed in terms of stochastic displacement from a long-run, two-price
equilibrium.(xis taken as exogenous;the model focuses on the impact of changes
in (xon spot and contract price adjustment in response to transitory supply and
demanddisturbances.
90 QUARTERLYJOURNAL OF ECONOMICS

respectively. Because of the definition of contracts, shocks (un-

anticipated exogenous changes in demand or force majeure in-
terruption of contract completion) are absorbed through adjust-
ment on the spot market. In this paper the parameterization of
the two-price system is taken as given.8
Consider, for example, the case in which a negative supply
shock initially raises the spot price relative to the contract price.
The presence of contracts implies that the spot market price (Ps)
is not the cost of a marginal unit, because a buyer could purchase
oil at a lower contract price (PC), but would have have to commit
himself to buy oil at that price for the duration of the contract.
The relevant price for purchase decisions thus is
(1) Pt = UPC + (1 - a)PS
Note that P differs from the average acquisition cost because of
prices paid on existing contracts. The resulting tradeoff involves,
inter alia, the mean and variance of the distribution of expected
prices and the relative case of importers in adjusting production
and inventories. These factors underlie the optimal value of a.,
taken parametrically here.
Equilibrium spot and contract prices must be equal as long
as buyers are risk-neutral. An interruption in contract supply
(est < 0) affects prices as follows. Given planned contract output
of aQ, where a caret over a variable denotes its value in the initial
equilibrium, there is excess demand at the prevailing contract
price. The spot market, with output of (1 - a) Q plus a price-
responsive addition of QS(Plt), functions to absorb (demand and
supply) disturbances. That is, the spot price solves
(2) (1 - a)QD(P) + FDt = (1 - O)Q + QS(ps) + t

Under the simplifying assumptions of linear responses of spot

supply and demand to price, we have
(3) QD(Pt) = A - fPt,

8. Carlton [1979] focuses on the incentives for contracting from the point of
view of the supply side. Buyers are in fixed categories-spot versus contract.
Sellers choose between the spot market and long-term contracts accordingto the
spreadbetween the two prices adjustedfor the variance of the spot price. Hubbard
and Weiner [1984] pursue the task of characterizingprice flexibility in markets
exhibiting both fixed-priceand flexible-pricebehavior.In general, the contracting
regime and hence the degree of price flexibility are shown to depend on the risk
aversion of the transacting parties, the variance of the spot price, and the co-
variances of the spot price with buyer and seller profits in the absence of con-
tracting.
 SUPPLY

and
(4) QS(Ps) = gps
Hence, equation (2) can be rewritten as
(5) (1 - ot)(A - f(tPtc + (1 - a)PS)) + Dt
= (1 -Ot)Q + gPS + Est,

or
(6) Ps = (1 - 0)0(A - Q) - fat(1 - a)r Pt + P(FDt - Est))

where
(7) = (g + f(1 - U)2)-1.
Letting lowercase letters denote variables in deviation form, we
may write equation (6) as
(8) PS = fat(1 - a)I P + (Dt -Est)
Holding a. fixed, we can totally differentiate (6) to evaluate
the impact of an oil supply shock on the spot price in the current
period; i.e.,

(9) dtp _ -
- fa(1 - a) P dt
dF'st d~st'
Hence, a supply interruption raises the spot price in the short
run, since dpsIdest = - P < 0. This reaction to shocks in the oil
market goes in the other direction for a demand shock. Since
dalda > 0, the greater is the fraction of transactions carried out
under contracts, the greater will be the adjustment in the spot
price required to clear the market in response to a shock. As the
secondterm in (9) indicates, to the extent that contract prices are
adjusted only gradually, the effects of disturbances on the spot
price are destabilizing. The ultimate impact on the spot price of
negative supply shocks depends on the way in which new contract
prices adjust to market imbalances.
Formalizingthe adjustmentprocessof long-termcontractprices
is a crucial step toward understanding price dynamics in the oil
market and evaluating the merits of government policy responses.
Contract price adjustment over time must be able to distinguish
between transitory shocks to demand or supply and changes in
underlying parameters (e.g., the slope of the demand function).
As a general form, suppose that the contract price is determined
by
92 QUARTERLYJOURNAL OF ECONOMICS

(10) pC = 1rlptc- + mT2Etptc+1 + + >

y(Oixt 02Etxt+D), Y 0,
where x represents demand faced by the nondisruptedproducers;9
i.e., under the simplifying assumptions from before,
( 11) ~~Xt=-fPt + F-Dt - FSt

Equation (10) implies that the contract price is set in the current
period after considering the history of prices and the expectation
of the price to prevail next period. Demand factors are also ex-
amined for their information about short-run and long-run mar-
ket conditions.10Using the definition of the composite price and
assuming that the weights on past and expected future prices and
on past and expected future demand factors sum to unity, we can
combine terms, simplifying (10) as1"
(12) pc(l + yOlft(l - f(l - ot)2p)) =TlP*_1 + [(1-1)
- (1 - 01)(fy(1 - f( - ot)2 1
3))]Etpct+
+ YO1 (1 - -
f(l O-)p)(FDt FSt).

If expectations are rational, solving the second-orderinhom-

ogeneous difference equation in (12) by standard methods yields12

9. This approachfollows Taylor's [1979, 1980] analyses of aggregate wage

and price behavior.
10. Past prices could be important in setting prices in the current period
because of transactions costs involved in always gathering new estimates of de-
mand. For example, contract prices may not respond immediately to excess de-
mand or supply because of the inability to distinguish between temporary and
permanentchanges. Expectedfuture prices may reflect expectationsabout chang-
ing market structure, new technolgies, etc.
11. The assumption that the weights on past and expected future prices sum
to unity is done for simplicity and for the purpose of considering changes in wi.
The qualitative results will hold for any (i,, WT2)and (01,02) combinationsas long
as drr2ldarl< 0, and d021dO< 0.
12. The solution is accomplished as follows. Let qt = yOi(l - f(l - o03)
(EDt - -st), and let h = (1 + -ylifa(l - f(l - o)2P)). Guess a coefficient ti such
that Etpt+1 = OptsThen (12) becomes

hpt = N1P*- + [(1 - sn) - (1 - 0i)(foy(l - f(l - O)2t)) 'pt + 't,

or

P h - [(1 - 7r ) - (1 - 0i)(f(X~y(j - f(l - ()2,))] P

+ ht
h - [(1 - si) - (1 - 1)(fot~y(l - f(l - Ot)2,p))]qj.
 SUPPLY AND PRICE IN THE WORLDOILMARKET 93

(13) Pt' = 4ptP- 1 + W(IDt -St),

where
X= yO(l - f(1 - ot)&)[1+ yOifa(1 f(1 - f) -

(14)
-14 ((1 - 191) - (1 - 01) (fot-(1 - f(1 - 0X)'PM -1 > 0,

and where 4 is the root within the unit circle of the quadratic
equation:
[(1 - 1r1)- (1 - 1)(fcc*y(1- f(1 - 0&21))]W2
- (1 + _y01ifx(l - f(1 - t)2p))4 - 7 = 0.
First, considerthe case of an oil supply interruption (FSt < 0).
The immediate impact of the supply reduction on the contract
price depends on the sensitivity of contract prices to excess de-
mand in the oil market, on the extent to which price determi-
nation is "backward-looking,"and on the slope of the demand
function. The shock not only generates an immediate increase in
the price,but the effect of the shocks persists even when the shocks
are in no way serially correlated because of the gradual contract
price adjustment.
Three relationships between the persistence parameter 4 and
the underlying structural parameters are important here. First,
since d4lda1 > 0, the greater the extent to which price setting
depends on information contained in past prices, the greater is
the persistence of the shock; when the future prices are not con-
sidered at all (,m,= 1), the reaction to transitory shocks is just
as great as the reaction to a permanent shift in demand. Second,
d4ldf < 0; the greater is the slope of the demand curve for oil,
the smaller is the initial increase in price and the lower is the
Now, 4' = ITi{h - [(1 - 'rF) - (1 - Oi)(fLy(1- f(l - so that
L)2r))]+4}-1,
Ah - [(1 - w ) - (1 - O1)(foy(l - f(l - o0) p))]q2 = 7Ti,

or
[(1 - - (1 - O)(fU-y(l - f(l - cX)2p))]q'2 - he' + iTr = 0,
the solution to which is
= (1 + -yOfOL(1- f(1 - OL)2p+y)i)(
2[(1 - 7T,) - (1 - O1)(fnr'(l _ f(l - -L)2p]

- f(l - (X)2p))2 - 4'7T,[(1 - 7T,) - (1 - O1)(foty(l - f(l - Ot)23))]}1/2/2{[(1 - 'rT)

- (1 - 010(foy(1- f(l - 0a) 0))2]}.

For stability, the root must lie within the unit circle; hence (13) above.
94 QUARTERLYJOURNAL OF ECONOMICS

persistence. Hence, policies such as oil import tariffs or certain

types of buffer stock price stabilization policies (which effectively
raise f ) can mitigate both the impact and long-run effects of
transitory shocks on prices.13Third, dqldac> 0, so that the larger
is the fraction of trades carried out under long-term contract, the
greater is the persistence.
The equations governing the evolution of prices illustrates
the effects of persistence. The responses of spot and contractprices
to negative supply shocks in the current period and in previous
periods are

(15) dP i= 0
d(- ESt-i)

=- fcd-(w1_tx i~, iA*O.

and
(16) dptc
d(- Est-i)

The responses of the two prices to shocks can be ascertained

fromequations (15) and (16). The spot pricejumps, then falls back
over time as the contract price adjusts. Long-termcontract prices
follow a smoother path in response to a shock. These responses
depend on the parameters of the demand and spot supply func-
tions, the share of total trades carried out on the spot market,
the extent to which producers are "backward-looking"in setting
long-term prices, and the sensitivity of contract prices to demand
factors. Figures I-IV show the within-period and cumulative ef-
fects of a negative supply shock on spot and contract prices, under
two conditions of persistence, To and +1, where 'k < To.
The spread between the spot and contract prices depends on
the importance of contracting and the way in which the contract
price adjusts to transitory shocks. A change in the parameters
occasioned by a change in producer behavior or by policy inter-
vention on the part of oil-importing countries can alter this re-
lationship. Industry reports and observations indicate that effec-
tive spot sales (in the sense of single-cargo transactions or
13. Forexample, oil importtariffs have been advocatedto decreasethe demand
for oil imports. In the context of the model presented here, the imposition of an
ad valorem tariff raises the slope of the demand function and lowers the impact
of a supply shock on the current-periodspot price. Since the intertemporal cor-
relation of price changes depends negatively on f (i.e., d4Idf < 0, persistence is
reducedby the imposition of the tariff. An extension to the effects of public stra-
tegic stockpiling is discussed in Hubbardand Weiner [1986].
 SUPPLY AND PRICE IN THE WORLDOIL MARKET 95

RESPONSESOF OIL PRICESTO TRANSITORYNEGATIVE

SUPPLY SHOCKS

S
dp
Pt

to1

FIGURE I

Effect of a TransitoryShock on the Spot Price

dpt

to t

FIGURE II

Effect of a TransitoryShock on the ContractPrice

dS
dpt IN

to t

FIGUREIII

CumulativeEffect of a TransitoryShock on the Spot Price

(continuedon next
96 QUARTERLYJOURNAL OF ECONOMICS

RESPONSES OF OIL PRICES TO TRANSITORYNEGATIVE

SUPPLY SHOCKS (CONTINUED)

*'

dpt

c ,
to t

----4 = 41' +

FIGURE IV

Cumulative Effect of a Transitory Shock on the ContractPrice

arrangements with frequent price adjustment) have risen from

about 10 percent in the late 1970s to about two-thirds of the
market in the mid-1980s.14Given this increased importance of
the spot market in the oil trade in the 1980s, the findings above
imply that future supply shocks should cause smaller fluctuations
in spot prices relative to prices in term contracts.15Hence, econo-
metric modeling efforts to isolate structural relationships among
prices in the oil market for the purpose of predicting the impacts
of supply shocks or of policy interventions on oil prices must
carefully address the two-price issue.16

14. See, for example, the discussion in "Oil Markets Reconsidered-1984and

Beyond,"PetroleumIntelligence Weekly,April 22, 1985.
15. In a related effort deriving the optimal value of (x in a static model,
Hubbardand Weiner [1984] show that the increased variance of the spot price
and the relative importanceof supply shocks over demandshocksduringthe 1970s
should decrease the use of long-term fixed-pricecontracts.
16. While the discussion thus far has considered only white-noise distur-
bances, the analysis can be easily extended to the case of serially correlated
quantity shocks. Supposethat demand and supply shocks follow AR(1) processes;
i.e.,
EDt = PD EDt- 1 + VDt, and Est = Ps ESt-1 + VSt,

where vDtand vst are white noise and aVDvS = 0. Note that equation (10) can now
be written as
P~t+{[(1 - 7ri) - (1 - 01) (ficy(l - f(l - ot)2r))] - (1 + Y0ifci(1 - f(l - t)2P))
L + i1L2} = - (FD EDt - YS YSt),
 SUPPLY AND PRICE IN THE WORLDOILMARKET 97

III. EMPIRICALIMPLICATIONS
The importanceof changes in contractual arrangements (and,
ultimately, the endogeneity of those arrangments) for statistical
relationships among prices suggests the difficulty inherent in in-
terpreting the effects of future shocks or policy responses on oil
prices and price adjustment. Approachingthe problemin a frame-
work similar to that developed in studies of the copper market
cited earlier, Verleger [1982] offers an explanation of the persis-
tence result above based on OPEC'sprice determination process,
suggesting that contract oil prices adjust to spot market prices
only with a lag, so that both analytical and policy attention should
be focused on spot market outcomes.
Verleger uses the oil inventory acquisition behavior of firms
and the process by which OPEC adjusts its contract prices to spot
market prices as the focal points of his explanation of why tran-
sitory supply shocks can lead to a permanent increase in ("upward
ratcheting" of) long-term world oil prices. He notes a statistical
correlation between contract prices and lagged spot prices of the
form,17

(17) PC = ao + +
aPC-, a2Pst-.
Verleger's estimated coefficients on P_ 1 and Ps-, imply a very
slow speed of adjustment of contract prices to spot prices, so that
transitory changes in spot prices exhibit serially correlatedeffects
on contract prices.
The principal problem with that approach, however, is that

where L denotes the lag operator,and where

FD = _Y(l - f(l - 0A) (1 + PD (1 -0/01)),
and
Is = yOi(l - f(l - ct)p) (1 + Ps (1 - O)IO)).
The solution method is analogous to that for the transitory-shockcase. Of
course,the existence of serial correlationamplifies the price effects of the shocks.
In addition, if the shocks are serially correlated, then changes in 4 induced by
policy changes or changes in market structure have all the more impact; see
Blinder [1982] for comparisonwith results for a one-pricemodel.
17. In Verleger's model, Pc represents the official oil price, and Ps represents
the spot productvalue (i.e., a weighted average of spot values of various products
taken from a barrel of crude oil). The coefficientson P%_ 1 andPts 1 are constrained
to sum to unity. He estimated equation (17) by ordinary least squares and by
instrumental variables methods, using quarterly data over the period from the
first quarter of 1975 to the third quarter of 1980.
98 QUARTERLYJOURNAL OF ECONOMICS

if the pricing rule used by contract sellers is of the general form

of equation (10), then (i) the appropriate marginal price for re-
finers and for policy decisions is not the spot price, but a weighted
average of the spot price and the price at which new contracts
are being signed; (ii) spot prices are not exogenous (in a causal
sense) to contract prices if changes in contracting (indicated by
the value of ax)occur, though the speed with which contract prices
are adjusted should be important for the determination of spot
prices,18and (iii) instability in the contract rules over time might
reflect changes in the weight placed on past prices, in the re-
sponsiveness of demand to price changes, or in the equilibrium
fraction of trades carried out on the spot market.
To illustrate the likely instability of statistical relationships
between spot and contract prices, we can consider the sensitivity
of the relative magnitude of spot and contract price adjustments
to shocks to changes in (vertical) market structure. For example,
a reduction in the estimated coefficient on the lagged contract
price can be interpreted in terms of the model of the previous
section as reflecting such institutional developments as a rise in
the importance of the spot market in world trade (decrease in a)
and more rapid adjustment of contract prices to market fluctua-
tions (through an effective shortening of contracts, i.e., a decrease
in s,).
Using equation (17) as an example, note that Table II below
displays estimated coefficientsfrom a regressionfor Mideast Light-
34 crude oil of the official contract price on its own lagged value
and the lagged spot price. The data used are monthly, covering
the period from 1974 to 1984.19 While the full-sample results
compare favorably to Verleger's findings, the model is unstable
across subperiods(here taken to be before and after 1980).2oThese
estimates in Table II are not intended as a formal test of a model
of price adjustment (which would also require a model of the spot
market to be useful for analyzing the impacts of shocks on prices),

18. That is, recalling equation (9), the principal econometricdifficulty with
modeling spot and contract price outcomes as being sequential is the implied
assumptionthat the fraction of trades carriedout under fixed-pricecontracts and
the speed at which prices on new contract adjust to shocks are time-invariant.
19. Data were taken fromPetroleumIntelligence Weekly[various issues]. The
values of the estimated coefficients changed little when the sample period was
begun in 1975.
20. This instability also occurredover otherbreakpointsduringthe 1979-1980
period.
 SUPPLY AND PRICE IN THE WORLDOILMARKET 99

TABLE II
INSTABILITYOF STATISTICALRELATIONBETWEEN SPOT AND CONTRACTPRICESIN THE
WORLD OIL MARKET

Model: Pc = ao + a, Ptc-1 + a2 Pt-1 + Et

Interval ao a, a2 K2

1974:1-1984:12 0.333 0.906 0.081 0.975

(0.718) (0.020) (0.024)
1974:1-1979:12 2.767 0.576 0.187 0.937
(0.840) (0.104) (0.034)
1980:1-1984:12 0.916 0.897 0.072 0.935
(1.128) (0.032) (0.022)
Standarderrors are in parentheses.Equation (17) was estimated by ordinaryleast squares over the
varioussampleperiodsindicatedabove.Data on spot and contractpricesare for MideastLight-34crudeoil.

but as an indication of the importance for market adjustment of

changes in the structure of vertical transactions.21
These qualificationsare similarly summarizedby Bohi [1983],
who cautions that institutional changes, particularly in the role
of the spot market in the world oil market, can affect statistical
relationships among prices in the market.22On the basis of formal
causality tests, he finds [pp. 23-25] "that there is substantial
feedback among all price pairs except those involving the spot
price, indicating that all prices by the spot price are simultane-
ously determined." Because the way in which long-term prices
are determined is crucial to spot price adjustment to shocks, one
would expect that, while spot prices per se might add little in-
dependent information to a regression of contract prices of their

21. It is worth noting that estimates for 4 in (13), where pc is defined as the
deviation of the current-periodcontract price from the a twelve-month rolling
averageof the spot price,are substantiallyhigher overthe 1974-1979 or 1974-1980
periods than over the 1980-1984 or 1981-1984 periods. This is consistent with
the predictionsof the model, given the decline in term contracting noted by in-
dustry sources.
22. Like Verleger, Bohi concentrates on the oil supply shock of 1979-1980.
Based on data on stocks for the United States, he concludes that the important
movement in oil inventories in 1979 was the sudden surge in the downstream
demand for refined petroleum products. That is, the principal factor in oil price
increases in response to supply interruptions in consumer "hoarding."He points
out that, if refiners misinterpret the transitory character of hoarding, upward
pressureis put on both spot and contractprices. To test the "hoardinghypothesis,"
Bohi examines the relationshipbetween consumerpricesto officialcontractprices.
No formalmodel of differencesin the relationships among the prices as a function
of institutional trading arrangements is presented, however.
100 QUARTERLY
JOURNALOFECONOMICS

own lags, contract price responses are quite important for spot
price determination. This is indeed what Bohi found.
Equation (9) demonstrates these points clearly. As the spot
market increases in importance, spot price responses to supply
disturbances are muted. Hence, attempts to use the spot price as
an indicator of market conditions in a time-series model of con-
tract prices are not likely to be successful. Principal implications
for energy policy are two: (i) the value (in terms of lower world
oil prices) of such energy emergency policies as oil import tariffs
and releases of oil from public stockpiles is not invariant to the
contracting structure in the market; and (ii) increases in the spot
price per se will not serve as meaningful "triggers" for policy
action if the importance of spot transactions in world oil trade
changes over time.

IV. CONCLUSIONS
Within the Walrasian paradigm of neoclassical economics,
goodsare traded costlessly on auction markets. Since transactions
are anonymous, only one price can prevail in a given market.
Casual observation suggests that many markets fall between the
"completeadjustment"and "no adjustment"extremes. Price rig-
idity is not limited to industrial product markets; certain com-
modity markets exhibit multiple prices because of contract rig-
idities, with petroleum being the best known example. This paper
focuses on the influence of the two-price system in the oil market
on the impact of transitory supply disturbances on prices.
The paper integrates short-run and long-run approaches,em-
phasizing the relationship between short-term "spot"prices and
long-term "contract"prices and its importance for price adjust-
ment in the aftermath of transitory shocks. In the model outlined
in the second section, the two prices are jointly determined. Tran-
sitory shocks affect both prices, though the response of each is
different. Even transitory shocks are shown to exhibit persistence
effects on long-term prices. The relationship between spot and
contract prices depends on the way in which the long-term price
(at which new contracts are signed) adjusts to transitory shocks.
The implied persistence of those shocks depends on structural
parameters (e.g., the weight placed by contract sellers on the
informationcontained in past prices, the fraction of trades carried
out through contracts, and the price responsiveness of demand).
A change in the parameters of the system occasionedby a change
 SUPPLY AND PRICE IN THE WORLDOILMARKET 101

in producerbehavior or by policy interventions of importers can

alter this relationship. In addition, persistence declines as the
fraction of trades carried out on the spot market increases.
An obvious implication of the theoretical model is that re-
cursive econometric formulations of the relationships between
prices are likely to be unstable and of limited use for policy eval-
uation. Some previous empirical studies and some issues in de-
signing and interpreting econometric work are discussed in Sec-
tion III. Advancement of the model of the two-price system to
general equilibrium by developing the division between spot and
contract trades from optimizing behavior will facilitate consid-
eration of the impact of changes in structural parameters on the
divergence of the two prices in response to shocks.
The construction of simulation models using a range of pos-
sible parameter values can be valuable for considering which
policy responses appear robust in their potential benefits. Em-
pirical examination of other commoditymarkets that have under-
gone changes in pricing regimes would be useful. Better under-
standing of the causes of multiple-price systems and their impact
on price and quantity adjustments in response to disturbance is
an important step toward explaining market (and aggregate) fluc-
tuations.

NORTHWESTERNUNIVERSITY, HARVARD UNIVERSITY,AND

NATIONALBUREAU OF ECONOMICRESEARCH

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