In late February 2026, the outbreak of the U.S.-Iran conflict led to the disruption of shipping through the Strait of Hormuz. Brent crude futures surged by 63.3% in March, marking the largest monthly increase since 1988.

The sharp rise in oil prices has already triggered alarms in the meeting rooms of central bank officials across major economies—not because they attempt to predict oil's next price movement, but because every sharp fluctuation in oil prices can set off a chain reaction in the macroeconomy: rising oil prices directly push up costs in transportation, manufacturing, and other sectors, forcing imported inflation to seep into CPI and PPI, potentially even driving core inflation or reshaping public inflation expectations. If oil prices continue to climb, forming a “wage-price spiral,” central banks will have to walk a tightrope between stabilizing growth and controlling inflation, potentially adjusting interest rate policies at any moment to balance risks.

Conventional wisdom holds that oil price spikes are primarily driven by supply disruptions—such as OPEC production cuts, geopolitical conflicts, or pipeline failures. However, research by Lutz Kilian, Senior Economic Policy Advisor and Vice President at the Federal Reserve Bank of Dallas, has overturned this narrative. He pioneered the decomposition of oil price shocks into three categories: supply disruptions, aggregate demand, and precautionary demand shocks. This distinction is not merely academic: misjudging the root cause of an oil price shock can lead to erroneous policy responses. Policymakers, including central banks, should not mechanically react to oil price movements but should precisely identify the fundamental drivers behind oil price increases and formulate policies accordingly.

As a leading scholar in the global oil market field, Kilian has published a series of papers over the past two decades decomposing the underlying drivers of oil price fluctuations, and has been repeatedly named a “Highly Cited Researcher” by Clarivate. From evaluating strategic petroleum reserves and measuring the impact of energy sanctions to providing guidance for central bank interest rate decisions, Kilian's research consistently demonstrates that the real logic of the oil market is far more complex than news headlines suggest.

The Real Story of Oil Prices

The oil market is a complex giant system that influences global inflation, geopolitics, and macroeconomic cycles. Kilian is not satisfied with the superficial narratives commonly seen in the media, which simplistically attribute oil price fluctuations to geopolitical conflicts or speculative trading. Instead, he strives to use rigorous econometric models to dissect vast amounts of data, revealing the true driving logic behind oil price volatility and its complex consequences.

In 2009, Kilian published his foundational work in oil research, “Not All Oil Price Shocks Are Alike,” in the American Economic Review (AER). This paper directly challenged the consensus in economics since the 1970s that overemphasized supply shocks. In this seminal study, he innovatively constructed a structural vector autoregression (SVAR) model to decompose oil price movements into three types of shocks: crude oil supply shocks (such as physical supply disruptions due to geopolitical conflicts), global aggregate demand shocks (such as those driven by global economic expansion), and precautionary demand shocks (such as hoarding demand driven by market panic over future shortages).

Kilian's empirical findings overturned prior understanding: different types of oil price increases have distinct impacts on the global economy. Oil price increases driven by global economic prosperity are often offset by strong macroeconomic demand. Surprisingly, pure supply disruptions have relatively limited negative impacts on the economy. The most severe stagflationary blows to consuming countries often come from precautionary demand surges triggered by panic and uncertainty. This work provides crucial theoretical foundations for central banks on how to accurately identify the sources of shocks and adopt differentiated monetary policies when responding to oil price fluctuations.

Taking the oil price crash from 2014 to 2016 as an example, when oil prices plummeted from over 100 per barrel to below 30, many analysts initially attributed this to the U.S. shale revolution flooding the market with excess supply. Kilian's framework tells a more complex story: the slowdown in global real economic activity played a substantial role, rather than a pure supply shock.

To date, this paper has been cited over 5,800 times, profoundly influencing subsequent research in energy economics and macroeconomic monetary policy.

Beyond Oil

In 1996, Kilian earned his Ph.D. in economics from the University of Pennsylvania. He then taught at the University of Michigan for nearly two decades, establishing his reputation as a world-leading expert in energy economics and applied econometrics.

In 2019, he joined the Federal Reserve Bank of Dallas. Texas, as the core oil and gas producing region in the United States, provides the Dallas Fed with deep expertise in energy market research, offering Kilian an ideal platform to directly apply cutting-edge academic research to policy practice.

Prior to this, economists typically used OECD countries' industrial production indices or global GDP to measure global oil or commodity demand. Kilian astutely pointed out the limitations of these traditional indicators: low data frequency, significant lags, frequent substantial revisions, inadequate reflection of emerging market demand growth, and the inability of output indicators to accurately represent real demand pressure for industrial commodities.

To address these issues, he innovatively proposed using the global dry bulk one-way freight rate index as a proxy variable to construct the “Index of Global Real Economic Activity” (Kilian Index). In his view, in the short term, the supply of global dry bulk carriers (for raw materials like iron ore, coal, and grains) is extremely inelastic, and sharp fluctuations in shipping freight rates can most timely and accurately reflect changes in global industrial commodity demand.

The creation of the Kilian Index enabled econometric models to effectively separate global aggregate demand shocks from oil price fluctuations. Using this index, Kilian demonstrated that the sharp oil price increases from 2003 to 2008 and the oil price crash from 2014 to 2016 were primarily driven by global demand-side factors, rather than the traditionally assumed supply shocks.

Currently, the Kilian Index is regularly updated by the Dallas Fed and publicly available in the Federal Reserve's FRED database, becoming a standard tool in energy economics and commodity market research.

Although energy economics remains his primary focus, Kilian has also made significant contributions to broader issues in applied econometrics. His co-authored book with Helmut Lütkepohl, Structural Vector Autoregressive Analysis, systematically reviews the econometric foundations, identification strategies, and practical applications of structural VARs, becoming a classic textbook in the field.

Addressing New Challenges

As the global energy landscape undergoes profound changes, Kilian's research continues to face new questions: How do oil price shocks truly affect current inflation dynamics? What are the transmission mechanisms of geopolitical conflicts to the global economy? Against the backdrop of potential structural transformations in energy markets over the next two decades, how should economists build forward-looking models?

Kilian maintains the caution characteristic of an empirical scientist. He acknowledges that the energy transition will eventually reshape markets but warns against hastily declaring traditional supply-demand logic obsolete. “From the current perspective, renewable energy will meet the additional energy demand generated by continued global growth, while oil demand growth will slow down or even decline slightly,” Kilian says. “However, in the petrochemical industry and long-distance transportation, there are no obvious substitutes for oil and gas yet.”

In Kilian's view, the energy transition will be a decades-long process. During this period, the fundamental economic laws of the oil market remain remarkably stable, and he will continue to use data and logic to seek truth amidst the fog of the oil market.

Interview with Lutz Kilian

1. PKU：Your seminal work on decomposing oil price shocks into supply disruptions, aggregate demand, and precautionary demand shocks has been foundational to understanding oil markets. However, since the Russia- Ukraine conflict and rising geopolitical fragmentation, many argue that geopolitical risk premia now dominate traditional supply-demand fundamentals. Do you believe the structural drivers of oil prices have fundamentally changed? How should we update your decomposition framework to capture this new reality?

Lutz Kilian：

· The short answer is that geopolitical risk has always mattered in oil markets, going back to the emergence of the global oil market in the 1970s.

For example, in my early work with Robert Barsky in 2001 we forcefully argued that geopolitical risk in oil markets was an important driver of the price of oil even in the 1970s, 1980s and 1990s.

There is a long history of modeling geopolitical and other oil price risks.

The precautionary demand shock in the empirical model of the global oil market you alluded to was a first step toward recognizing that uncertainty about future oil prices (including geopolitical oil price risk) drives the price of oil beyond the forces of flow supply and flow demand shocks found in textbook models.

· However, precautionary demand driven by oil price uncertainty is only part of this channel.

Equally if not more important are shifts in the expected price of oil, as markets anticipate future geopolitical supply disruptions or global economic expansions and contractions.

For example, if I expect the oil price to go up (perhaps because I expect the Strait of Hormuz to be closed), I will buy oil now, while it is cheap, keep it in storage, and sell that oil at a profit when the oil supply disruption occurs, so both inventories and the price of oil go up immediately.

The challenge is that oil price expectations are not observed, so how do we know when the oil market is responding to oil price risk?

The key insight here is that we don’t need to measure expectations because any response to oil price expectations (or for that matter to oil price uncertainty) will be reflected in higher oil storage demand.

By augmenting the oil market model to include a proxy for the change in global oil inventories and modeling the determinants of these inventories, we were able to infer whether expectations have moved and how much they have changed the price of oil and other model variables.

· Most recently, in joint work with colleagues at the Dallas Fed, we have pushed this analysis further seeking to jointly model expectations and inventories and to allow for nonlinearities in the effects of geopolitical oil price risk.

We develop a dynamic nonlinear model of the global economy with oil prices that respond to demand and supply shifts in the economy.

The model’s novelty is that it allows the probability of a major disruption of global oil supplies to vary over time.

This allows one to trace out the response of the global economy to probability shocks as a function of the magnitude of the oil supply shortfall, its expected duration and the persistence of the probability.

The model can capture not only the anticipation of geopolitical events, but also their realization. This is particularly useful in the context of 2026 conflict in the Persian Gulf.

2. PKU：Your research emphasizes the critical role of global aggregate demand in driving commodity price cycles. Given China's economic slowdown, demographic shifts in major economies, and the energy transition away from fossil fuels, do you believe we are witnessing the end of the commodity "supercycle" that began in the early 2000s? Or are we entering a new, fragmented cycle driven by different structural forces?

Lutz Kilian：

· I am agnostic about the existence of a “supercyle”.

There was much interest in identifying long and short cycles in economic fluctuations in the 1920s.

That literature died away long time ago because identifying cycles based on fairly short spans of data is difficult and, ultimately, not that useful for understanding what’s driving the data.

Much the same concerns apply to the literature on commodity price cycles that emerged more recently.

· I fully agree that demographic shifts in many countries, the shift away from globalization in trade, the energy transition, and recent disruptions in energy flows all make modeling oil and other commodity markets more challenging.

· The problem is not that the determinants of the oil price have changed:

(1) Instead, one challenge is that imperfectly separated regional energy markets are harder to model than one global market.

(2) Another challenge is temporary dislocations in energy markets with implications for the cost of shipping, which we normally abstract from.

(3) A third challenge is that the structure of many economies is changing. For example, the U.S. used to be a major net oil importer, but its oil trade balance is close to balanced now, which affects how oil price shocks are transmitted to the economy.

· This means that time series data from the 1970s and 1980s have become less useful for empirical work. We are back to working with very short samples.

That’s why I expect quantitative theoretical models to become more important for understanding changes in energy markets going forward.

3. PKU：You have written extensively on the role of speculation in oil markets and the informational content of crude oil inventories. In recent years, commodity markets have become increasingly financialized, with the proliferation of ETFs, algorithmic trading, and passive index investing. Do these developments fundamentally alter the price discovery mechanism? Should we still rely on inventory data as a reliable indicator of physical market tightness, or has financialization decoupled prices from fundamentals?

Lutz Kilian：

· Financialization may affect the transmission of oil price shocks to other financial markets and to the economy, but financialization does not fundamentally alter the price discovery mechanism.

There is an arbitrage condition linking physical and financial oil markets that ensures that prices in these markets move together.

Research shows that oil futures prices contain no information that goes beyond the information contained in models of the physical oil market.

· In general, financialization does not decouple prices from fundamentals.

In the early days of financialization some researchers thought of financial investors deciding to try out investing in oil for no particular reason.

That’s of course not what happened.

Rather these financial investors were attracted by the high rates of returns they would have realized, had they anticipated the global economic boom that started in 2002.

It was fundamentals driving financialization rather than financialization driving up oil prices.

4. PKU：The global energy transition toward renewables and the push for carbon neutrality represent unprecedented structural shifts. How do these transitions affect the traditional models we use to understand and forecast oil and commodity prices? Are the historical relationships between oil prices, GDP growth, and inflation still valid in a world increasingly powered by renewables and constrained by carbon policies?

Lutz Kilian：

Renewables are about electricity.

Oil in many countries does not play a major role in electricity generation, so to a first approximation renewables don’t matter much for modeling oil markets.

They do matter to some extent for modeling the transmission of oil price shocks.

· It appears that for the time being renewables will satisfy the additional energy demand arising from continued global growth, while the demand for oil grows more slowly or slightly declines.

In other words, the oil market is here to say.

· As to the effect on the economy, the increased reliance on electricity as the primary form of energy in production and for local transport reduces the dependence of the economy on oil, lowering the share of oil in GDP, which is one of the key parameters in macroeconomic models.

· In addition, when oil prices surge, the ability to substitute toward EVs could make the demand for oil more elastic, but such effects likely take time to materialize and are limited.

While the precise nature of this relationship may evolve, oil markets will remain an important determinant of growth and inflation in our lifetime.

For example, there is no obvious substitute for oil and gas in the petrochemical industry (e.g., plastics, fertilizer, rubber, paint and adhesives) or for long- distance transportation.

5. PKU：Your work has explored the linkages between monetary policy, the U.S. dollar, and commodity prices. With recent aggressive Fed tightening and ongoing discussions about "de-dollarization" in commodity markets (e.g., yuan-denominated oil contracts), do you see a weakening of the traditional dollar-commodity relationship? How might the emergence of alternative pricing and settlement systems reshape global commodity markets?

Lutz Kilian：

· There is no doubt that a number of countries would prefer commodity trade not to be denominated in U.S. dollars.

This convention has favored the U.S. economy and given the U.S. the power to impose more effective sanctions than other countries.

· Even granting that there is unease abroad more generally with recent economic developments in the U.S., the challenge for other countries is that there is no obvious alternative to the U.S. dollar.

· The reason why commodity trade is denominated in dollars ultimately is that the dollar remains freely convertible, is relatively safe from inflation, is accepted almost everywhere, and its price is determined in markets.

Likewise, the Euro which is convertible, relatively stable, and widely accepted, has not managed to become a rival to the dollar in commodity trade, perhaps because it is a much younger currency.

· It would likely take major economic instability and/or a far diminished role of the U.S. economy in the global economy, for traders to abandon the dollar in favor of another currency.

Coordinating on one currency facilitates trade. Traders will not go out of their way to experiment with other currencies unless there is a compelling reason.