The Real Risk of Oil Price Shocks

story_images_oil_gas_miningAs a speaker at this summer’s Risk Management Conference in Muskoka (August 13 to 15) Lutz Kilian, Professor of Economics at the University of Michigan willl speak about oil price risks. In advance of the conference, we asked Lutz to tell us what these risks look like and how investors can quantify oil price risk. To find out more about Lutz’s presentation and the Risk Management Conference, click here.

Oil price shocks have hurt economic growth and investments in the past. What is the prospect that they can be repeated, e.g., through turmoil in the Middle East?

One key insight from recent research is that economists for years may have overestimated the impact of oil price shocks. Statistically speaking, we now know that oil price shocks on average have been associated with lower growth, but have been far from the main explanation of recessions.

Another key insight is that no two oil price shocks are alike. Some oil price shocks are associated with rising stock prices and a booming economy while others are associated with falling stock prices and slower growth. In other words, there is no mechanical relationship between the economy, financial markets, and the price of oil.

In fact, oil prices usually do not change all else equal, but are associated with changes in many other economic variables. As a consequence, we need to know whether a given oil price shock is caused by turmoil in the Middle East, for example, by a physical supply disruption, or by a booming world economy, before we can assess the implications for the U.S. economy. In each case, the response of the U.S. economy will be quite different. It is certainly possible for future oil price shocks to be associated with sharp economic declines, but it is also possible for rising oil prices to be a symptom of economic strength.

For turmoil in the Middle East to trigger large oil price increases, it typically has to be the case that the market expects higher demand for oil than can be met with expected oil supplies. Political tensions in the Middle East therefore need not always be associated with rising oil prices. The Tanker War in the Persian Gulf in the mid-1980s is a good example. Under the right circumstances they can be very powerful market movers indeed, however.
How does North America’s growing energy independence factor into the equation, particularly since West Texas now sells at a discount to Brent?

The price of oil is determined in global markets. Even if the U.S. were to increase its oil production substantially, consumers would end up paying the price of oil prevailing in global markets. Thus, consumers would not be insulated from the vagaries of world markets.

The recent decline of the WTI price relative to other oil price benchmarks is a case in point. Broadly speaking, this decline reflects the fact that there is an excess supply of U.S. and Canadian crude oil in Cushing, Oklahoma. Under normal circumstances that oil would be exported, and arbitrage would eliminate the price difference, but this has not happened because of physical and legal restrictions on U.S. crude oil exports. This does not mean, however that consumers in the U.S. face a lower gasoline price and are getting a bargain. Rather refiners are charging consumers the same price as the marginal barrel of oil imported into the U.S. and keep the difference. Thus, the only obvious way for consumers to partake in the local oil boom would be own the right oil stocks or to be involved in domestic oil production.

There has been a surge of institutional interest in commodity futures markets. Does this alter the   traditional supply/demand equation?

The short answer is no. It is not possible for speculative demand by institutional investors to increase both oil futures prices and the spot price without also shifting oil inventory demand in the physical market for oil. It has been shown empirically that there is no evidence of a shift in inventory demand between 2003 and 2008, ruling out this conjecture. This finding is particularly striking because there is ample evidence of speculative motives mattering during some earlier oil price shocks.

This is not just a question of lack of evidence, however. It has also been shown that shifts in economic fundamentals are sufficient for explaining the evolution of the price of oil during this period, even during 2007 and 2008. There is a consensus among experts that the primary explanation of this oil price surge is unexpectedly strong global demand for oil. There is little else that remains to be explained. Thus, a more natural view is that institutional investors in oil futures markets simply responded to perceptions of high returns on oil triggered by shifts in fundamentals.
Do oil futures markets have an impact beyond the investors in the asset class?

Oil futures markets provide another venue for market participants to hedge risks beyond the traditional channel of accumulating physical inventories. Sometimes oil futures markets are viewed by investors as a means of diversifying portfolios, but recent evidence shows that oil futures markets and other asset markets have become increasingly integrated, undermining that rationale. This increased co-movement of returns, of course, also reflects the fact that oil price fluctuations in recent years have largely reflected the state of the global economy.

Can you give an example of scenario analysis?
Forecasters often focus on what the most likely path for oil prices is. There are well-established tools for answering this question. Sometimes, however, we wonder how sensitive such baseline forecasts are to certain hypothetical future events. For example, we may wonder how an unexpected global economic recovery would impact the future path of the price of oil. This is not to say that we view this recovery as likely, but that it seems prudent to think through the implications of such a hypothetical event.

A structural model of the oil market such as the model developed by Baumeister and Kilian (2012) can be used to develop such a forecast scenario. For example, one can interpret a global recovery as a return to a situation of high global demand for oil and other commodities, as prevailed between 2007 and mid-2008. By imposing in expectation a sequence of global oil demand shocks similar to that which drove the surge in the price of oil in 2007/08, we can infer how much higher the path of the price of oil would be in this global economic recovery scenario. Similar tools may also be used to evaluate other scenarios from political unrest in the Middle East to an unexpected physical disruption of oil supplies. It is even possible to combine different forecast scenarios.

To learn more about the Risk Management Conference, please visit the conferences section of the CIR website. If you are interested in attending this event, please email Alison Webb to be considered, as limited space available.