Sources of the Volatility Puzzle in the Crude Oil Market

A remarkable feature of the crude oil market is a dramatic rise in oil price volatility over time which has been accompanied by a substantial fall in oil production volatility. We investigate the sources of this opposite evolution of both oil market variables. Our main …nding is that the observed volatility puzzle can be rationalized by the fact that the price elasticities of both oil supply and oil demand have decreased considerably over time. This implies that small disturbances on either side of the oil market generate large price reactions but only modest quantity adjustments. We also document that the variance of structural shocks which shift the oil demand and supply curves has become smaller in the more recent past thereby even mitigating oil price ‡uctuations. JEL classi…cation: E31, E32, Q43 Keywords: Oil prices, volatility, time variation, price elasticities We thank Luca Benati, Matteo Ciccarelli, Lutz Kilian, Vivien Lewis, Davide Raggi, James Smith and Paolo Surico for insightful discussions and helpful comments. We acknowledge …nancial support from IUAP and FWO. All remaining errors are ours.