Macroeconomic impacts of oil price volatility: mitigation and resilience

Abstract

Dependency on oil-derived fuels in various sectors, most notably in mobility, has left the global economy vulnerable to several macroeconomic economic side effects. Numerous studies have addressed the effect of price volatility on specific economic parameters. However, the current literature lacks a comprehensive review of the interactions between global macroeconomic performance and oil price volatility (OPV). Price volatility is intrinsic in commodity markets, but has been advancing at a faster rate in the crude oil market in comparison to other commodities over the past decade, reflecting the status of oil as the most globalised commodity. In this paper, the analytical literature review and analysis of the behavioral responses of macroeconomic agents to OPV shows that such volatility has several damaging and destabilizing macroeconomic impacts that will present a fundamental barrier to future sustainable economic growth if left unchecked. To ensure macroeconomic isolation from OPV, a combination of supply and demand-side policies have been recommended that can help to mitigate and build resilience to the economic uncertainty advanced by OPV.

Graphical abstract

Keywords

conventional oil / price volatility / macroeconomy / economic stability / energy security

1 Introduction

Not long ago, anyone who had mentioned that the United States would likely become energy independent or would have said that they could consider exporting fossil resources would have received roaring laughter. The energy market in North America has, however, undergone a full transformation and neither energy independence nor the US as a fuel exporting country is an unrealistic assumption. This is good news for the economy as will be laid out in this study, but bad news for greenhouse gas emission and looming climate change, as one of us has explained in a publication co-authored with Friedrichs [1]. But is it really the price of energy commodities that impacts macroeconomic stability and growth? In this paper, the effect of the price of energy resources on macroeconomic issues will be assessed comprehensively using the obvious choice — oil.

Fossil fuels have represented the lifeblood of the global economy ever since the long-term trajectory shift in global output, income, and population growth, led by the Industrial Revolution. Today, world energy consumption continues to be dominated by fossil fuels, which constitute almost 90% of the global energy mix [2], and in particular by crude oil, which displaced coal as the dominant world fuel source in the mid-1950s. However, the burgeoning use of oil has come at both a significant environmental and economic cost, the latter in part reflecting the significant macroeconomic uncertainty associated with oil price volatility (hereafter referred to as OPV).

OPV is defined as the standard deviation of oil prices in a given period. The economic uncertainty generated by the extreme volatility of oil prices has important consequences for the global economy that differ markedly from the impacts of oil price shocks. While the economy-wide implications of oil price shocks as well as the upside and downside potential in oil prices have been extensively studied, the literature examining the macroeconomic effects of OPV remains relatively underdeveloped. Through a comprehensive survey of the OPV literature, this paper highlights the fundamental concerns posed by price volatility for the global economy and examines the behavioral responses of macroeconomic agents to OPV, with a view to highlighting the policy trade-offs involved with minimising volatility and its associated economic risks. The results of this paper will inform the supply and demand-side priorities for policymakers who are faced with the challenging task of minimising adverse macroeconomic impacts associated with OPV.

The nature of oil prices changed fundamentally after the 1973 oil embargo by the Organisation of Arab Petroleum Exporting Countries (OAPEC). Prior to 1973, for instance, US oil prices displayed low volatility across broad time periods and approximated a step function, due to the distinct regulatory structure of the oil industry from 1948 to 1972 in which state regulatory services such as the Texas Railroad Commission assigned permissible production levels based on their one-month-ahead forecasts of petroleum demand [3]. Post-1973, oil prices began to exhibit nonlinearity and unprecedented levels of volatility, a characteristic that has increased sharply during the major supply disruptions over the past four decades, and which continues to typify the oil market today. Oil prices reached their historical high of $147 per barrel midway through 2008, only to drop sharply to below $40 per barrel by the end of the year. Such acute oil price deviations have increased the vulnerability of the global economy to crises by generating considerable economic uncertainty. Figure 1 depicts the average monthly nominal Brent Crude price (US dollars) and standard deviation from 1988 to 2013.

The inception of the International Energy Agency (IEA) in November 1974 was a direct response to the price volatility impacts of the 1973-1974 OAPEC oil embargo. The foundational remit of this institution delineated its coordinative role in assisting member countries to issue a collective response to major disruptions in oil supply through the release of emergency oil stocks to markets [4]. This core energy security mechanism, which still remains the nucleus of the IEA today, requires that IEA member countries maintain emergency oil reserves equal to the value of 90 days of net oil imports so that the economic repercussions of significant supply-side oil shocks can be mitigated through their release. The US Strategic Petroleum Reserve, which has the capacity to hold 727 million barrels of oil, is the largest such emergency reserve of crude oil in the world [5]. However, while the IEA security mechanisms provide an effective supply-side risk management solution, they are unable to entirely reduce OPV because the supply of oil is characterized by significant inelasticity (vide infra) and because supply-side oil disruptions only partially drive price volatility.

2 Drivers of OPV

Reflecting the status of oil as the most globalised commodity, oil prices have historically exhibited greater levels of volatility than other commodities and asset prices [6]. There are three main drivers of OPV: characteristics of oil market fundamentals, speculation in the oil derivatives market, and inadequacies in oil market data.

2.1 Characteristics of oil market fundamentals

The physical demand and supply of oil constitute the fundamentals of the oil market. The short-run demand and supply of oil are both strongly price inelastic [7], meaning that marginal changes in either oil demand or supply induce greater than proportional oil price changes and, often, large price deviations. From a long-term perspective, growth in OPV has been primarily attributable to the decrease in the price elasticities of both oil supply and demand since the mid-1980s [8]. Over the past decade, the transition of both oil demand and supply toward a more inelastic state has become particularly apparent. Despite the unprecedented demand-led growth in oil prices over the 2003-2008 period, for instance, conventional crude oil production stagnated from 2005 to 2008 [9]. In contrast, global oil demand, remained resilient, as increases in the demand for oil in the BRICs and the Middle East, more than offset decreases in the demand for oil in Western Europe and North America.

The increasing inelasticity of oil supply has been fuelled by several factors, most notably decreasing conventional oil production capacity and rates of new discovery, as well as blockages to new oil market investment. Infrastructural investment in the oil sector in Iraq, for example, has been more-or-less stationary over the past decade, reflecting a significant investment risk due to political and national instability. And while unconventional oil reserves are presently seeing increasing rates of exploitation in many countries around the world, slower production rates in comparison to conventional reserves are significantly reducing the pace at which producers are now able to respond to price changes [10].

Demand-side inelasticity has been primarily driven by the decades-long structuring of the global economy around oil, particularly in the case of the transportation sector, in which oil powered transit and associated infrastructure retains market dominance, despite the increasing popularity of alternatives such as electrically powered vehicles. This structural dependence on oil has been augmented by extensive and institutionalised fuel consumption subsidies in non- OECD countries, which have dampened substitution effects and preserved oil demand at an artificially high level [11].

In addition to the inelastic nature of both oil supply and demand, there are several specific supply and demand-side factors that aggravate OPV. Oil supply, for example, is vulnerable to unquantifiable sources of instability, such as regional conflict in producing areas, theft, and the uncertainties raised by the nationalisation of oil companies, which can lead to significant disruptions in both investment cycles and short-term supply availabilities. Global ratings agencies, for example, have pointed toward the potential for both growing regulatory and investment uncertainty for foreign and domestic companies wishing to invest in the Argentinian oil industry, following the nationalisation of Yacimientos Petrolíferos Fiscales (YPF) in 2012. The demand for oil, on the other hand, exhibits cyclical tendencies and seasonality [12] so that the relationship between the demand for oil and real output is procyclically contemporaneous [13]. Inherent business cycle volatility is thus also likely to make itself manifest in oil prices. The relationship between oil prices and business cycles is augmented by the fact that oil demand is more responsive to changes in income than changes in prices [14].

Disruptions caused by political tension and conflict in oil producing regions have historically held the greatest weight in explaining the largest fluctuations in oil prices [15,16], and evidence suggests that market participants continue to respond strongly to the potential for supply disruptions in producing nations experiencing political turmoil. The 2011 Libyan Civil War and continuing geopolitical tensions centered around the Iranian nuclear program, for example, have both placed significant upward pressure on oil prices [17].

However, the explanatory power of supply-side shocks has somewhat deteriorated over the past decade, because the largest producers are now undertaking significant efforts to stabilize prices by offsetting decreasing regional supply with increasing production in other jurisdictions [18]. For instance, Saudi production levels reached their 30-year high in the first financial quarter of 2012 and were maintained at well above their average level throughout the year in an attempt to offset geopolitical tensions [19]. But it is important to note that the potential for such supply coordination is becoming significantly limited by the growing domestic use of petroleum in producing countries. More than a quarter of the oil produced in Saudi Arabia, for example, is now consumed domestically, reflecting the impact of extensive and institutionalised fuel consumption subsidies, which have prevented domestic fuel prices from reflecting their true market value [20]. This means that higher oil production will not immediately or necessarily translate into larger export availabilities.

In addition to unprecedented producer efforts to stabilize prices, the IEA collective response mechanism has markedly mitigated the potential for severe price volatility on several recent occasions. The 2011 Libyan Civil War, for instance, saw IEA member countries release 60 million barrels of oil to mitigate supply disruptions of Libyan light sweet crude. This markedly reduced tightness — the main drive of short-term OPV (vide supra) — in the prompt supply of light sweet crudes [21].

On the demand-side, growing but steady patterns of oil consumption in emerging economies (where demand growth has been centered over the past decade) are equally unable to account for intense swings in crude oil prices. Instead, a popular explanation of the fortification of OPV in recent years is that the progressive financialisation of the crude oil market has led to its transformation from a largely physical market into a complex and predominantly financial market [18].

2.2 The oil derivatives market and its price impacts

2.2.1 Origins and purposes of the oil derivatives market

After the damaging economic impacts of the 1973 oil crisis, a consensus emerged acknowledging the critical need for the creation of effective risk management mechanisms in the oil market, similar in utility and scope to the contemporary risk management systems in foreign exchange markets. In response, a diverse set of financial instruments was adapted to allow oil industry actors to effectively manage capital and diversify risk, becoming collectively known as the oil derivatives market. Since its inception, the oil derivatives market has grown exponentially in size and is now at least 14 times larger than the physical oil market [22]. Its precise dimensions are, however, difficult to gauge given the bifurcation of the market between regulated exchange-traded derivatives contracts and unregulated over-the-counter (OTC) derivatives contracts.

With technological advancement, the range of financial tools available to investors has gradually expanded and increased in complexity, enabling new forms of transaction and behavior to evolve in accordance with the market. However, these new operations have increasingly diverged from the raison d'être of the market.Oil derivatives were originally devised and intended to be used to guard and hedge against the uncertainty generated by price volatility. But non-commercial investors have increasingly been using oil derivatives for a different purpose all together: to accept financial risk in exchange for prospective reward. Such speculative activity has been driven by the belief that exploitable inefficiencies exist in financial markets.

2.2.2 Efficient markets and Hotelling’s rule

Building on earlier research which advanced the idea that the path of stock prices follows a random walk, Eugene Fama proposed in his efficient markets hypothesis (EMH) that the informational efficiency of financial markets renders it impossible to use price trends and information to achieve consistently above average stock market returns [23]. Arbitrage — a riskless profit obtained through the simultaneous sale and purchase of an asset to take advantage of price disparities [24] is thus unattainable if the EMH holds. For finite resources in particular, the economic theorist Harold Hotelling argued that arbitrage is impossible [25]. According to Hotelling’s rule, the net price of a non-renewable resource such as oil, should rise at the market interest rate in a purely competitive market equilibrium, in order to reflect the appreciation in the value of exhaustible resources as reserves are depleted.

2.2.3 Market inefficiencies

However, all available evidence suggests that both the EMH and Hotelling’s rule, with respect to the crude oil market, have not been held in reality, due to the various inefficiencies that characterize the crude oil market(vide infra). The main prediction of Hotelling’s rule that oil prices should be characterized by an upward trend over time, and stand in opposition to historical oil price movements. Excluding episodic volatility, oil prices generally decreased over the 1980-2000 period. Factors such as technological change, political disruption, revised expectations relating to the availability of resources, and the structure of the global oil market, have all historically played a more significant role in dictating price trends [26], reflecting the fact that the Hotelling model’s assumption of a perfectly competitive market failed to fit the structural form of the oil market. The oil production quotas imposed over the 1982-1986 period by Organisation of the Petroleum Exporting Countries (OPEC), for example, represented a significant disruption to natural market dynamics [27]. Moreover, such market disturbance was augmented by the non-formulaic nature of OPEC production ceilings [28]. In the view of the WTO, the market structure of non-renewable resources is thus better characterized as imperfect [29]. But, providing that the oil market becomes more transparent and less ‘imperfect’ over time, this dynamic could change. The waning power of OPEC, for example, has significantly reduced non-competitive market pressures [30], and may provide an explanation as to why with the exception of oil prices in 2009, the price trend over the 2003 − 2012 period followed the predictions presented by Hotelling’s rule.

In opposition to the predictions of the EMH, behavioral economists emphasizse that herding behavior, which has prevailed in the crude oil market [31−33], and human data processing errors have created market inefficiencies, leading prices astray. For example, increases in index fund flows have been found to accurately predict higher oil futures prices three months later, while the flows of managed money spread positions have been shown to positively affect future oil prices [34]. Oil derivatives markets are now also displaying a strengthened relationship with seemingly unrelated markets. For example, despite sharing wholly different fundamentals, the cross-market correlations between West Texas Intermediate (WTI) Crude futures and the Euro Stoxx 600 and Standard and Poor’s Goldman Sachs Commodity Indexes (S&P GSCI) have evolved from displaying approximately no correlation to a near perfect correlation over the course of the past decade [17,34,35]. Such developments suggest a non-fundamentals based explanation of OPV.

2.2.4 Speculation as a driver of price volatility

A large body of evidence suggests that speculative activity has divorced oil prices from solely reflecting developments in market fundamentals on specific occasions. The increased volatility and upshot in crude oil prices during the 1990-1991 Persian Gulf War, for example, occurred with no analogous alteration in oil supply. Price developments during this period, instead, solely reflected uncertainty [36]. In addition to their price impact during the 1990-1991 Persian Gulf War, speculative demand shocks were a critical determinant of the volatility in oil prices in 1979 (following the Iranian Revolution), in 1986 (following the collapse of OPEC) and in 1997-2000 (following the Asian financial crisis) [16]. However, current evidence (vide supra) related to new cross-market correlations suggests a systemic increase in the price volatility impacts of speculation quite apart from the outlier impacts of speculation during exceptional oil market episodes over the past decades. With financial investors providing the key link between unrelated markets, previously intangible volatility spillovers from the stock market to the oil market and vice versa, appear to have been institutionalised.

Furthermore, the dominance of herd behavior in the oil derivatives market as the market has expanded [18], has compounded existing volatility associated with market fundamentals, through the amplification of upswings and downswings already implied by movements in physical market demand and supply, as high frequency and short-term trading positions have gained in popularity and increased in financial significance. Such complex interplay between speculative activity in response to developments in market fundamentals and activity based on recent price trends rather than market fundamentals has added to the diverse set of conflicting factors within the oil market and created a self-sustaining source of price volatility.

While there are still significant academic divisions regarding the precise impact of speculation on volatility (partly reflecting disparities in the methodology and time periods considered in the causal analyses of volatility), the impact of speculation on volatility appears to be relatively muted in comparison to other market factors. In his analysis of the drivers of the oil price shock of 2007-2008, for example, James D. Hamilton concluded that while the flow of speculative investment influenced the ‘miscalculation’ of oil prices in 2008, the stagnation of production since 2005 together with highly inelastic demand had greater explanatory power [37].

2.3 Inadequate market data

Herd behavior is, in part, precipitated by inadequacies in the transparency, accuracy, and availability of critical oil market data, including inventories and estimations of current and future quantities of oil demand, supply, production, stocks, and reserves. Uncertainties regarding such variables have impacted OPV by shifting the information sources that guide investment decisions from relatively inaccessible but pertinent oil market data to accessible yet comparatively uninformative trends in recent oil prices [6].

The joint organisations data initiative (JODI) was specifically created to address the link between OPV and the opacity of oil market information. Its core institutional aim is to improve the accessibility and accuracy of oil market data in order to moderate excessive price volatility. However, while the initiative has made much progress on improving data transparency, results are not yet optimal because data submission rates by member countries have been declining for the past three years. Moreover, the timeliness of data submissions remains inconsistent, creating additional uncertainty [38]. The JODI database is also not subject to external review and does not cover the data relating to oil reserves [39]. While this data is published by several independent sources, non-uniformity in the reporting of both volumes and grades places the accuracy of such estimates under considerable ambiguity and, moreover, restricts direct comparability [40]. The IEA, for example, incorporates natural gas liquids, refinery feedstocks and additives in its definition of crude oil; all of which are excluded in the definition of crude oil employed by the Energy Information Administration (EIA). Non-standardised data collection and reporting methods, are the norms across a range of physical oil market variables, the corollary being sizeable variations in market forecasts across different agencies. A forecast disparity amounting to approximately 30 million barrels per day exists, for example, between IEA and OPEC forecasts of cumulative oil demand up to 2035 [41]. Such data deficiencies drive volatility by hindering the formation of accurate medium to long-term price expectations. Countering inadequacies pertaining physical market data thus requires greater international and institutional collaboration to ensure homogeneity in data collection, variable definitions, coverage and statistical representations, and may also require an expansion in coverage to include more diverse and underappreciated market variables. For example, improved coverage of oil tanker traffic could be useful in providing an alternative measure of production.

In addition to the informational deficit in the physical oil market, opacity and non-uniformity in both regulatory standards and coverage characterize several variables of interest in the oil derivatives market. Publishing of the categorisation and positions of traders, for example, is not a constitutional requirement on the main European bourse trading in oil derivatives, the Intercontinental Exchange, Inc. (ICE), whereas the disclosure of this information is mandatory for participants on the New York Mercantile Exchange (NYMEX). But despite differing national regulatory structures, identical derivatives contracts are traded internationally; the WTI Light Sweet Crude Oil contract, for example, is common to both ICE and NYMEX.

3 Effects of OPV

3.1 Asymmetrical response of macroeconomic activity to oil price changes

“Oil prices have fallen lately. We include this news for the benefit of gas stations, which otherwise wouldn’t learn of it for six months.”

One reason that the volatility of oil prices matters fundamentally more in terms of economic output than the level of oil prices is that OPV has been found to amplify the asymmetrical response of economic activity to oil price changes—a phenomenon first documented by the economist Knut Anton Mork [42]. Mork’s findings show that oil price increases have a proportionally greater (and negative) impact on economic activity than the corresponding positive economic impact of oil price decreases. The intensification of the asymmetrical economic output response to oil price changes under OPV has since been confirmed by several national studies of the impact of OPV on macroeconomic variables [43−49].

3.2 Literature survey

Literature examining the link between OPV and economic activity strongly suggests that OPV negatively affects economic output in the short to medium-term [43−57]. Adverse short-term economic impacts largely reflect the deterioration of aggregate demand as OPV intensifies. Aggregate consumption and investment, for example, immediately decrease in response to the economic uncertainty created by OPV [43,48−54,57,58], a dynamic which is augmented by volatility driven unemployment [50,54]. While industrial production has also been found to decline in the short-run [43,52,53,57], production declines are more likely to be a response to downward trends in aggregate demand than to production cost uncertainty. This is because industrial producers respond to production/input cost uncertainty by raising product prices to incorporate an uncertainty premium, rather than by reducing production levels [59]. In the medium-term, aggregate supply is more responsive than aggregate demand to the effects of OPV. This is foremost the product of decreasing investment in the short term which results in constrained production capacity and increased supply-side inelasticity in the medium-term. Other negative economic effects of OPV in the medium-term such as inflation [48,56,57,59], are also likely to stem from supply-side responses to OPV; the aforementioned uncertainty premium, for example, precipitates increasing inflation.

4 Responses to OPV

The literature survey has indicated that the occurrence of certain events is probable in the precarious economic environment created by OPV; inflation and unemployment are both likely to increase, while investment, stock market returns, consumer demand, and industrial production are likely to decrease. However, under certain circumstances, counterbalancing influences and moderating responses can offset some of the economic effects of OPV discussed thus far. This section explores the viability of such responses to examine whether OPV will necessarily lead to a decline in the constituent elements of aggregate demand and supply, in the short, medium, and long-term. This analysis will help to clarify the trade-offs involved with minimising price volatility and inform section 7 of this paper, which focuses on the priorities and areas of focus for policymakers who are faced with the task of minimizing the adverse macroeconomic impacts of OPV. Figure 2 illustrates the direct and indirect responses to OPV.

4.1 Direct responses to OPV

OPV directly impacts three primary macroeconomic channels: consumption, investment, and industrial production [43,46−54]. The precise extent to which these variables are affected is dependent on two factors: the degree of uncertainty generated by OPV; and the attitudes of economic agents to uncertainty. Hereafter, the possible responses of consumers, investors, and producers to OPV are analyzed in order to understand the optimal policy response(s) to OPV.

4.1.1 Consumption

Declining consumer demand under OPV [46,49−51,58] reflects the fact that the uncertainties advanced by OPV, regarding future income and employment prospects, decrease consumer confidence [60] and prompt consumers to adopt precautionary savings behavior at the opportunity cost of current consumption [49,58]. This confirms the principal prediction of precautionary savings literature that by reducing the average propensity to consume (the percentage of income spent rather than saved) greater economic uncertainty should result in declining aggregate consumption [61−64]. In the medium-term, volatility-driven unemployment [50,54] augments downward pressures on aggregate consumption by increasing consumer pessimism regarding future economic prospects and reinforcing existing precautionary savings motives [64]. Economic models, such as Hall’s random-walk model of consumption, also suggest that by increasing the uncertainty about future income, OPV should increase the stochasticity (randomness) of consumption [65].

4.1.2 Investment

Because investment is most responsive in areas where consumer demand is either resilient or expected to grow, the effects of OPV on aggregate consumption have a significant impact on investment decisions. Real options valuation literature suggests that, due to the uncertainties relating to the profitability of investment in a volatile energy environment, the benefits of holding a more risk averse investment portfolio outweigh the future advantages gained from current commitments to irreversible investment expenditures [66,67]. Evidence of decreasing aggregate investment as a result of OPV [47,50,51,68−71] suggests that firms do indeed optimise their investment expenditures in this fashion and that, parallel to the attitudes of consumers under OPV, investors are risk-averse. This commonality is in part driven by the fact that investment is determined by expected trends in consumer demand. In other words, the deterioration of aggregate consumption as a result of OPV has a negative bearing on current investment decisions by leading to the downwards revision of future demand expectations [49]. Additionally, stochastic consumption [65], in conjunction with the increased unpredictability of marginal production costs under OPV, has been found to significantly deter investment by amplifying the uncertainties related to future demand (and, hence, investment profitability).

However, as a result of differences in aggregate risk preferences between investors in financial and real markets, as well as the differences in the quality of risk compensating mechanisms in financial and real markets, financial investment may be positively correlated with OPV. Stock market returns, for example, may necessarily appreciate during periods of acute OPV, as investors demand higher risk premiums [72] to compensate for increased investment risk [71]. Furthermore, while frequent price deviations increase the chances of financial loss, such deviations also shape perceived opportunities for arbitrage. Thus, one consequence of OPV may be the deterrence of risk-averse investors and the attraction of risk-loving investors to financial markets. The degree to which volatility is detrimental or beneficial to stock market investment is thus a function of the prevailing risk preference in financial markets at any given time. In a risk-loving market, stock market investment can realistically increase alongside OPV.

The negative relationship between real investment and OPV is, additionally, only specific to the short and medium-run and disintegrates in the long-run, reflecting the fact that further delays to investment are subject to an increasing opportunity cost over time, as the strategic effort to establish market share through commitment to new technologies acquires greater importance [71]. In the long-run, therefore, aggregate investment will recover to pre-volatility equilibrium levels, regardless of the extent of price volatility in the market. Moreover, price volatility may actually drive increasing investment in the long-run if the volatility-induced switch in household behavior from consumption to precautionary savings in the short to medium-run enlarges the pool of savings available for funding investment [49,58].

4.1.3 Industrial production

Industrial production generally declines in response to aggregate price volatility [73], but the essentiality of oil as an input into industrial processes means that OPV has an especially adverse effect on industrial production growth [43,52,53,57]. Although the time horizons considered in investment and production level planning differ markedly, the central determinants of investment (expected consumption and returns) are also common to industrial production. The decrease in industrial production as OPV increases is a response to the expected decreases and increased unpredictability of consumption as well as production and delivery cost uncertainty, vide supra.

However, unlike the predetermined negative relationship between aggregate investment and OPV in the short term [71], industrial production levels may be maintained in the short term despite of the uncertainty created by price volatility, reflecting the differing production cost risk-management mechanisms commonly used by industrial producers and investors: contrary to the investor response of delaying expenditure as production cost uncertainty increases, industrial producers maintain production levels by increasing product prices to incorporate an uncertainty premium in order to compensate for increased production cost uncertainty [59].

4.2 Indirect responses to OPV

The impact of price volatility on consumer, investor, and producer behavior, strongly influences both the level of inflation and the level of unemployment within oil dependent economies [48,50,53−56,58]. This section explores the extent to which inflation and unemployment may indirectly increase in the short, medium, and long-term as a result of OPV, the relationship between inflation, unemployment and OPV, and the extent to which monetary policy can effectively regulate both the inflationary and deflationary pressures of OPV.

4.2.1 Inflation and monetary policy

Inflation is a natural by-product of the premium that industrial producers attach to the prices of their goods under production cost uncertainty. The high inflation rates throughout the 1970s can thus arguably be largely attributed to the sharp increase in OPV which occurred over the decade [48,59]. From this point of view, inflation may be interpreted as a ‘necessary evil’ in maintaining industrial production levels under OPV. The source of inflation, however, remains crucial in determining whether the impact of inflation on industrial production is positive or negative. If high energy prices are the cause of inflation, a negative correlation should characterize the relationship between industrial production and inflation, because higher energy prices imply an increase in production costs and a corresponding reduction in profitability. Rising energy prices during the first half of 2012, for example, boosted US Consumer Price Index (CPI) inflation while weighing heavily on US factory output [74]. On the other hand, if inflation is the product of an expansionary monetary policy response to OPV, industrial production is likely to be positively correlated to inflation.

While supply-side responses to OPV create inflationary pressures, demand-side responses, such as lower consumption and investment expenditure (vide supra), create deflationary pressures. These opposing deflationary and inflationary pressures carry different weights over different time periods and give rise to the U-shaped term structure of inflation under OPV. In the short-run, inflationary pressures created by supply-side responses to production cost uncertainty are likely to outweigh the deflationary pressures created by demand-side expenditure shifts, because of the lag before which consumers are able to form accurate expectations of how OPV will affect both the future economic outlook and the future level of inflation [75]. Consumers, therefore, do not immediately adjust expenditures downwards in response to OPV. In the medium-term, however, deflationary pressures created by reduced demand-side expenditure are likely to outweigh inflationary supply-side pressures, as fully formed inflation and growth expectations reduce consumption and force a proportional decrease in production levels. In the long term, inflationary pressures are likely to accumulate as the decline in investment expenditure in response to OPV in the short to medium-term⁷⁰ reduces production capacity and increases supply-side inelasticity.

Changes in inflation expectations strongly influence the orientation of monetary policy. OPV exacerbates the traditional policy dilemma faced by monetary policy authorities of lowering interest rates to directly promote economic growth (accommodative policy) or raising interest rates to limit inflation (tight policy), by creating inflationary pressures and simultaneously lowering economic activity [48]. This conflicting policy choice is likely to be fluid and responsive to business cycles as well as to the overall condition of the domestic economy.

In low-inflation economies, monetary policy authorities have more flexibility to pursue an output target, due to the greater capacity of low-inflation economies to sustainably absorb further inflation. Therefore, in a low-inflation environment, monetary policy authorities have a stronger incentive to focus on supporting consumption, investment, and production through expansionary monetary policy rather than limiting inflation through contractionary monetary policy. In addition to its beneficial impact on real investment, such a monetary policy response implies that financial investment could increase regardless of OPV, because a decrease in the interest rate (which represents the applied discount rate in the calculation of the current value of companies), should result in an increase in the value and share returns of stock market-listed companies [24]. Such conditions could feasibly precipitate an increase in financial investment, as investors rush to benefit from a market in which stock returns are appreciating.

However, such a simplistic view of monetary decision-making does not account for the role of expectations in determining the effectiveness of policy. A significant risk posed by the use of expansionary monetary policy to boost consumption, investment, and production under OPV, is the creation of a liquidity trap. The liquidity trap as formulated by John Maynard Keynes in his General Theory of Employment, Interest and Money [76], refers to a situation in which the approach of the nominal rate of interest toward zero fails to reverse the preference for saving. Since the nominal rate of interest cannot be negative, conventional monetary policy ceases to be effective in stimulating the economy when the nominal interest rate reaches zero. The Japanese economy in the late 1990s remains the most prominent example of this scenario [75], however, the low interest rates in European economies and the US over the past two years, which have failed to substantially increasing bank lending or consumer demand, also imply the existence of a wide-scale modern-day liquidity trap [77]. OPV directly increases the risk of a liquidity trap by adversely affecting consumer confidence [49,58,60]. In an environment in which low consumer confidence pervades, the cheaper availability of money is unable to overturn the precautionary savings behavior of consumers, which OPV encourages [49,58] This bottleneck has two fundamental implications for the future direction of monetary policy: the management of OPV should lie beyond the remit of monetary policy; and monetary policy should be more conservative. This reflects the fact that the necessarily forward-looking or pre-emptive nature of monetary policy [78], is ill-suited in addressing short-term price volatility. Moreover, despite the fact that the term-structure of inflation under price volatility is predictable, price volatility itself is difficult to predict. A less conservative expansionary monetary policy approach may unintentionally augment the inflationary pressures created by price volatility because of the limitations involved in the forecasting of OPV [79].

4.2.2 Unemployment

The increasing rate of unemployment under OPV [51,54,80] is precipitated by the decline in both industrial production and overall economic activity as OPV intensifies [43−57]. In periods of excessive OPV, an increase in the rate of unemployment occurs because the industrial workforce in the short to medium-term is more likely to wait in anticipation production level restoration (and commensurate job opportunities in the industrial sector) than to retrain for jobs that require alternative skill sets [81−85].

The extent to which unemployment is affected by price volatility depends on the contribution of the industrial sector to GDP and the structure of labor market laws. OPV is likely to lead to higher unemployment in economies in which the industrial sector holds a fundamental place in the sectoral composition of economic growth, than in economies in which the industrial sector plays a comparatively less important role. This explains why OPV has had such a significant impact on the rate of unemployment in the US [50,81] (the world’s second largest industrial producer), but relatively muted unemployment-impacts in service-based economies [86]. The structure of labor market laws also play a crucial role in determining the extent to which adverse industrial production and consumption under OPV are translated into higher unemployment. Over the past decade, government involvement in labor markets has decreased substantially in most OECD countries; however labor market structures within the OECD are still characterized by significant heterogeneity. The increase in unemployment under oil OPV in countries characterized by flexible labor markets including Estonia, Poland and the UK, is thus likely to be more severe than in countries with limited labor market flexibility such as Belgium, France, Italy and Spain [87]. The rigidity of unemployment levels in countries with less flexible labor markets may also explain the trade-off between inflation and unemployment implied by the short-run Phillips curve.

4.2.3 Stagflation

In the 1970s, the negative relationship between the rate of inflation and the rate of unemployment, graphically represented by the Phillips curve, ceased to hold. Unemployment and inflation, instead, rose in conjunction with one another in several countries, while economic growth was either stationary or declining, a condition known as stagflation. The finding that OPV both increases inflation and unemployment and decreases economic growth, suggests that OPV also pushes the economy into a stagflationary mode. The stagflation that pervaded the 1970s can arguably thus be largely attributed to the significant increase in OPV which occurred over the decade.

5 Dependency on crude oil and financial implications

In the context of the increase in oil prices and price volatility which has occurred over the past decade, the global dependency on crude oil has serious financial implications; chiefly, trade deficits are now foremost the result of expenditure allocated to crude oil imports (Fig. 3).

Expenditure devoted to crude oil imports as a percentage of the trade balance has significantly increased in the majority of OECD countries over the past decade, despite declining consumption. Crude oil import expenditure represented 86% of the UK trade deficit in 2011, up from 22% in 2003. This reflects a greater reliance on oil imports to fulfil domestic demand since the peak in UK oil production in 1999 [88], which ultimately shifted its position from being a net exporter to a net importer of oil in 2005 [89]. In contrast to the low oil prices faced by British oil exporters in the zenith of the UK oil export market in the 1990s, the position of the UK from 2005 onwards as a net oil importer coincided with the upward trend in oil prices beginning in 2003. The upward trend in oil prices over the past decade also explains why expenditure on imported crude oil has increased in countries where oil imports have been declining. Despite the decline in US crude oil imports since 2006, for example, expenditure on imported crude oil represented 65% of the US trade deficit in 2011, up from 36% in 2006.

Such adverse pressure on trade balances will worsen in oil-importing countries over the coming decades as the price of oil continues to increase. By 2035, the IEA estimates that nominal oil prices will reach $215 per barrel. According to the IEA, the US is also likely to approach energy self-sufficiency by 2035 [90]. But this does not imply that pressure on the US trade balance, as a result of increasing oil prices, is no longer likely to be a problem. Pressure on the disposable incomes and consumption patterns of US consumers would still remain high as domestic US oil prices are, after all, dictated by global market forces [91]. Thus, the possibility of future US energy self-sufficiency does not eliminate the macroeconomic problems created by the increasing trend in oil prices; it merely alters the specific framing of the problem.

In contrast to both the UK and the US, Germany has successfully maintained a trade surplus throughout the past decade, due to the vitality of its export sector [92], and its expenditure on imported crude oil as a percentage of the trade surplus has plateaued in recent years. However, this expenditure trend masks significant concerns for future German economic sustainability. Since 1995, German import dependency with regard to both petroleum fuels and crude oil and natural gas liquids (NGL) has remained above 93% [93]. And despite the fact that the expenditure devoted to imported crude oil as a percentage of the German trade surplus has stagnated over the past decade, Germany is still spending a substantial proportion of its trade surplus to finance domestic oil consumption. In 2011, for example, 29% of its trade surplus was used to finance oil imports.

Such acute import dependency can be hazardous in the event of a negative economic shock. For example, Greek expenditure on imported crude oil, which already constitutes an enormous proportion of the Greek trade deficit (77% in 2011), would increase unsustainably in the event that Greece exits the Eurozone. This is because the reversion to its old currency — the Drachma — comes at the cost of a significant devaluation. According to certain estimates, reversion to the Drachma would see Greece spending almost three times more on crude oil imports [94]. A visualization of the hypothetical increase in oil import expenditure under the Drachma in the event that Greece exits the Eurozone compared to the value of the Drachma when Greece first joined the Eurozone, is presented in Fig. 4.

6 Key messages

Price volatility in the crude oil market is increasing at a faster rate than volatility in other commodity markets, partly due to the status of oil as the most globalised commodity.

There are three main drivers of OPV: tightness, or the highly inelastic nature of both supply and demand, in the crude oil market; speculation in the oil derivatives market; and inadequacies in oil market data.

While improvements in the quality and transparency of oil market data will be important in lessening the extent of future price volatility, most of the price volatility that has occurred over the past decade reflects market tightness and speculative activity in the oil derivatives market. Realigning the use of the oil derivatives market toward its initial purpose (hedging) will be fundamental in managing future price volatility.

The uncertainty advanced by OPV has damaging and destabilizing macroeconomic effects. The high degree of OPV which has characterized the market for the past four decades represents a fundamental barrier to stability and hence growth. The management and reduction of price volatility will play a key role in enhancing stability in future economic growth trajectories, vide infra.

Policies to reduce price volatility must be balanced between the prevention and the cure of OPV.

Preventative policy should center around the stabilization of oil supply. The IEA collective response to the Libya crisis in June 2011, which saw member countries release 60 million barrels of oil to mitigate the ongoing supply disruption of Libyan light sweet crude, effectively reduced the potential severity of price volatility. Cooperation and concerted action of this kind will be fundamental in mitigating future price volatility.

The solution or ‘cure’, however, will be intrinsically linked to demand-side policies focused on reducing the global reliance on oil, achieving greater diversification in the global energy mix and increasing energy efficiency. In contrast to the antiquate adage, the cure is better than the prevention, because the instability and inelasticity of oil supply (the primary drivers of volatility) will only worsen over the coming decades as the quantity of conventional oil reserves diminishes.

Finally, future research needs to focus on the quantification and forecasting of OPV to allow policy makers to effectively prepare appropriate risk-management response mechanisms to address price volatility.

7 Policy interventions

Price volatility is primarily driven by supply-side factors but mainly has demand-side impacts. Policy to reduce price volatility and its associated adverse macroeconomic effects must therefore encompass both supply-side and demand-side solutions. The primary focus of supply-side (preventative) policy should be the stabilization of oil supply because the largest increases in price volatility have historically arisen from supply-side oil disruptions. To an extent, the market is self-correcting in this regard. Production practices from the largest oil producers in order to stabilize prices, such as the increased production levels in Saudi Arabia during the first half of 2012 to offset geopolitical tensions [19], suggest that oil producers are concerned about the adverse long-term demand-side impacts of sustained high oil price intervals and are unwilling to tolerate both high prices and volatility in the market. Despite this, the IEA projects that, nominal oil prices will reach at least $215 per barrel by 2035 [90]. Global cooperation and concerted action will thus be fundamental in the management and reduction of future price volatility. In this regard, the IEA collective action framework, which mandates the maintenance of strategic oil reserves, has recently been highly effective on several occasions in reducing the extent of price volatility in the context of oil-supply disruptions. The IEA collective response to the 2011 Libya crisis, for example, which saw member countries release 60 million barrels of oil to mitigate the ongoing supply disruption of Libyan light sweet crude, effectively reduced the potential severity of price volatility[21]. Strengthening and expanding IEA and analogous systems will thus be important in enhancing future market stability. One possibility might be the legislative requirement that companies and industries which are heavily reliant on oil powered production processes, should maintain individual strategic oil reserves to provide effective insulation from price volatility.

Supply-side risk management policies are important but at best can only minimise OPV and its associated macroeconomic effects. Macroeconomic isolation from OPV can only be achieved through a combination of supply and demand-side policies. Demand-side policy should prioritise strategies that reduce oil dependency, such as disincentivising oil consumption through tax and subsidy reform, improving sectoral energy efficiency and facilitating greater diversification in the global energy mix. Institutionalised oil price subsidies in non-OECD countries have augmented the global structural dependence on oil and provided little incentive for lowering oil consumption[11]. An important initial policy step would be the review of national energy subsidy policies to assess the areas in which there is greatest scope for both subsidy and tax reform in relation to oil consumption. Due to the fundamental dependence of mobility on crude oil-derived fuels, energy subsidy and tax reforms and improvements in energy efficiency must be all centered around innovations in the transportation sector. Fuel taxes have raised consumer awareness about the fuel economy of vehicles and have been particularly effective in improving fuel economy and reducing vehicle emissions in the European Union [95]. However, several strategies to improve energy efficiency in the transportation sector including the adoption of fuel-economy standards and the construction of codes and requirements for greater efficiency in power plants, have been restricted by poor government organization [96]. Significant political will is thus required to achieve effective policy reform related to energy efficiency standards. Governments must also play a role in creating a facilitating environment in which a diversified set of alternative and renewable sources of energy can thrive. Part of this role includes the re-alignment of financial industry in order to increase its contribution toward the funding of alternative energy sources [97]. Alternative fuels that have the potential to be used in the transportation sector, including algae derived fuels [98], natural gas [99], hydrogen [100], and decarbonised electricity [101], all require significant financial backing before they can become economically viable.

Finally, the significant growth and impact of speculation on price volatility over the past decade has highlighted the necessity of policies that constrain the misuse of the oil derivatives market. The European Commission’s proposed Financial Transactions Tax, which has the backing of ten countries and is expected to come into force in 2014, is unlikely to be adequate in tackling speculation on the oil derivatives market for two reasons: the proposed tax, which is estimated to be levied at 0.01% for derivatives transactions, is too small [102]; and the tax will not differentiate between speculators and hedgers and is thus only likely to increase the cost of hedging without specifically tackling speculation [103]. To effectively gauge and address speculative activity, policies to improve the systems of identification of traders and their respective positions are necessary so that regulators are better able to manage speculative activity. This may necessitate the adoption of an American style model in European trading exchanges. The mandatory classification of traders and their respective positions — an already institutionalised feature on NYMEX — could, for example, be exported to the ICE. Additionally, improvements in the general quality and transparency of both physical and financial oil market information would lessen market uncertainty and price volatility by improving the accuracy and homogeneity of price expectations. Strengthening and expanding the scope of oil market information and assessment systems such as Latest Energy, Metals & Steel News, Market Data and Analysis (PLATTS) and JODI by instituting policies to improve consistency and reliability in data submissions is thus essential in lessening future price volatility.

8 Conclusions

The high degree of OPV that has characterized the market for the past four decades represents a fundamental barrier to economic growth, due to its damaging and destabilizing effects on the macroeconomy. Through the generation of economic uncertainty, OPV adversely impacts aggregate consumption, investment, and industrial production, resulting in an indirect ripple-through impact on aggregate unemployment and inflation. Uncertainties pertaining to future income streams under OPV decrease consumer demand while increase the randomness of consumption. This prompts the decrease of physical investment expenditure in both the short and medium-term. However, as the pool of savings available for investment expands, greater aggregate investment is facilitated in the long term. Short-term financial investment, in contrast, may increase in response to OPV (depending on the degree of risk preference which characterizes the financial market at any given time) reflecting risk premium revision and perceived opportunities for financial gain as price deviations increase. Industrial production is also adversely affected under OPV, due to the impact of price volatility on consumer demand and production costs. However, because production cost uncertainty can be offset through price increases, OPV only guarantees declining industrial production in the short-run if its effect on consumption is greater than its impact on production costs.

The effects of OPV on consumer, investor, and producer behavior, strongly influence both the level of inflation and the level of unemployment within economies affected by OPV. Under OPV, the term-structure of inflation is likely to correspond to a U-shape, in reflection of the relative weights of the inflationary and deflationary pressures created by OPV over time. In response to the decline in industrial production, investment and consumption, unemployment also significantly increases under OPV. But the precise extent to which unemployment is affected by price volatility will depend on the contribution of the industrial sector to GDP and the structure of labor market laws. The finding that OPV both increases unemployment and inflation and decreases economic growth suggests that OPV pushes the economy into a stagflationary mode. The stagflation that pervaded the 1970s can arguably thus be largely attributed to the significant increase in OPV that occurred over the decade.

A combination of supply-side and demand-side policies aimed at preventing and providing a solution to OPV is vital if stability in future economic growth trajectories is to be achieved. An expansion of systems that mandate global cooperation and concerted action in oil supply chain management, such as the IEA collective action framework, is necessary in order to minimise short-term price volatility and promote market stability. In addition to supply-side disruptions, high frequency trading (speculation) is also a significant driver of short-term OPV. Policy must focus on realigning the use of the oil derivatives market away from speculation and toward its initial purpose: hedging. Improving derivatives market regulatory systems and working toward international derivatives regulatory standards will be vital in achieving this goal but efforts to curb speculation so far have been lacklustre. While a step in the right direction, the European Commission’s proposed Financial Transactions Tax, which is expected to come into force in 2014, is unlikely to be adequate in curbing speculation and its effects on oil prices because of the relative size of the tax (0.01% for derivatives transactions) and the lack of differentiation between speculators and hedgers in the tax structure. Instead, the tax may simply disincentivise hedging behavior at a time when hedging is vital. In the medium and long-term, the main task of governments should be to create a facilitating environment which incentivises infrastructural investments and the production of a diversified set of alternative renewable fuels that can be used as a substitute for oil, particularly in the transportation sector. Complementary to this are demand-side management policies to reduce the global structural dependence on oil. Part of this role will require the politically challenging task of energy subsidy and tax reform to incentivise the consumption of alternative fuels and disincentivise oil consumption, particularly in non-OECD countries where oil price subsidies have been institutionalised. But a significant opportunity in reducing the demand for oil is also to be found in policies that are aimed at improving energy efficiency such as the adoption of fuel-economy standards and the construction of codes and requirements for greater energy efficiency in various sectors of the economy.

It has not escaped out attention that the research presented herein strongly suggest that the significant production capacities of unconventional fossil fuel reserves coming online over the next decade are highly likely to mitigate price volatility and keep prices — at least relatively — low. While this is terrible news for the environment, it is excellent news for the economy: unconventional reserves could provide the dearly needed economic boost and they will “buy us time” for decarbonisation endeavors. On the long-run, these decarbonisation endeavors will be essential in order to increase sustainability, mitigate climate change and decrease dependence on fossil feedstock.

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