Oil Prices and Informational Frictions: The Time-Varying Impact of Fundamentals and Expectations

This paper accounts for informational frictions when modelling the time-varying relationship between crude oil prices, traditional fundamentals and expectations. Informational frictions force a wedge between oil prices and supply and/or demand shocks, especially during periods of elevated risk aversion and uncertainty. In such a context expectations can be a key driver of oil price movements. We utilize a variety of proxies for forward-looking expectations, including business confidence, consumer confidence and leading indicators. In addition, our paper implements a time-varying parameter approach to account empirically for time-varying informational frictions. Our results illustrate firstly that oil supply shocks played an important role in both the 1970’s and coinciding with the recent shale oil boom. Secondly, demand had a positive impact upon oil prices, especially from the mid-2000’s. Finally, we provide evidence that oil prices respond strongly to expectations but the source of the shock matter: business leaders’ expectations are positively related, while markets’ expectations are not strongly linked to oil prices.