Wednesday, July 25, 2012

Volatility vs. Price*

In recent years, the oil market has been characterised by rising, and at times, rapidly fluctuating price levels. In the last three months alone, Brent crude oil prices have fluctuated in a wide range from $125/bbl to $89/bbl. Higher volatility will certainly impact both consumers and producers. Oil exporting countries can be negatively affected by the impacts of high volatility in oil prices on fiscal revenues, investment and confidence in the economy. Higher volatility can have negative impacts on inflation and growth prospects in oil importing countries as well. As a response to observed higher prevailing volatility, for example, G20 leaders called for policy options to combat excessive price volatility in commodity markets in general, and in oil markets in particular. In order to reduce volatility in oil markets, the G20 experts group emphasised the importance of improving data transparency in both financial and physical markets as well as phasing out of inefficient fossil fuel subsidies. They also urged the use of country-specific monetary and fiscal responses to support inclusive growth in order to mitigate the impacts of excessive price volatility.

However, it is important to note that volatility itself is not the main problem. The main challenge is the elevated price levels combined with higher volatility. Oil prices, like those of many other commodities, are inherently volatile and volatility itself varies over time. Due to inelastic supply and demand curves, at least in the short run, any shock to demand and supply will lead to large changes in oil prices. For example, annualised average volatility in January 2009 peaked at 92%, followed by a rapid decline to relatively low levels. On the other hand, volatility reached its historical peak level (116% annually) in January 1991. Up until mid-March 2012, average annualised volatility in 2012 was relatively stable at around 23%. It is important to note that prices in this period increased from $110/bbl to $128/bbl. Volatility in Brent prices increased especially in June 2012, reaching more than 34% at a time when the price level declined by more than $15/bbl.

This pattern, volatility increasing as oil prices decline and volatility declining as oil prices increase, is consistent with the empirical evidence in the stock market. The increase in volatility when oil prices falls can be explained by the fact that falling oil prices often accompany deteriorating global activity and resulting uncertainties for global oil demand, such as the collapse in demand observed immediately after the demise of Lehman Brothers in September 2008.

Although policy makers and market participants generally point to peak oil prices in 2008, the average Brent oil price in 2008 was $96.94/bbl, only peaking at $144/bbl on 3 July 2008. Moreover, oil prices were above the $100 threshold level on only 128 days during 2008. Average Brent oil prices registered $61/bbl in post-September 2008 when the worst financial crisis since the Great Depression hit the global economy. In contrast, between mid-February 2011 and June 2012, oil prices have averaged above $100/bbl. The average Brent oil price registered $111.26/bbl and $113.17/bbl in 2011 and 2012, respectively. Given the fragile state of the global economic recovery, the impact of high oil prices on global growth, especially in oil importing countries, is potentially more severe now than in 2008. High oil prices already threaten to aggravate global economic slowdown by widening global imbalances, reducing household and business income, and boosting inflation.

This is not to say that volatility should have a second order of importance when considering market dynamics and oil prices. Prices and volatility cannot be separated from each other. However, persistently higher oil prices have been increasing the share of GDP spent on oil imports. This is especially the case in oil-importing developing countries because their economies are often more dependent on imported oil and more energy-intensive and because their energy use in a given sector is sometimes less efficient than the global average. Therefore, policies to deal with high oil prices should arguably be given priority over policies dealing with volatility. There are already many tools to combat oil price volatility, including not least at a micro level the use of commodity derivatives markets to hedge against price risk. Addressing elevated price levels may be a harder nut to crack however, unless price distortions in consumer markets on the one hand, and uncertainties in the upstream investment environment on the other are addressed, allowing markets to more readily self-adjust to international pricing signals. 

IEA Oil Market Report, July 2012

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