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Macroeconomic impacts of oil price volatility: Mitigation and resilience

Article in Frontiers in Energy · March 2014

DOI: 10.1007/s11708-014-0303-0

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Front. Energy 2014, 8(1): 9–24
DOI 10.1007/s11708-014-0303-0

REVIEW ARTICLE

Zoheir EBRAHIM, Oliver R. INDERWILDI, David A. KING

Macroeconomic impacts of oil price volatility: mitigation and

resilience

© Higher Education Press and Springer-Verlag Berlin Heidelberg 2014

Abstract Dependency on oil-derived fuels in various resources would have received roaring laughter. The
sectors, most notably in mobility, has left the global energy market in North America has, however, undergone
economy vulnerable to several macroeconomic economic a full transformation and neither energy independence nor
side effects. Numerous studies have addressed the effect of the US as a fuel exporting country is an unrealistic
price volatility on specific economic parameters. However, assumption. This is good news for the economy as will be
the current literature lacks a comprehensive review of the laid out in this study, but bad news for greenhouse gas
interactions between global macroeconomic performance emission and looming climate change, as one of us has
and oil price volatility (OPV). Price volatility is intrinsic in explained in a publication co-authored with Friedrichs [1].
commodity markets, but has been advancing at a faster rate But is it really the price of energy commodities that
in the crude oil market in comparison to other commodities impacts macroeconomic stability and growth? In this
over the past decade, reflecting the status of oil as the most paper, the effect of the price of energy resources on
globalised commodity. In this paper, the analytical macroeconomic issues will be assessed comprehensively
literature review and analysis of the behavioral responses using the obvious choice — oil.
of macroeconomic agents to OPV shows that such Fossil fuels have represented the lifeblood of the global
volatility has several damaging and destabilizing macro- economy ever since the long-term trajectory shift in global
economic impacts that will present a fundamental barrier to output, income, and population growth, led by the
future sustainable economic growth if left unchecked. To Industrial Revolution. Today, world energy consumption
ensure macroeconomic isolation from OPV, a combination continues to be dominated by fossil fuels, which constitute
of supply and demand-side policies have been recom- almost 90% of the global energy mix [2], and in particular
mended that can help to mitigate and build resilience to the by crude oil, which displaced coal as the dominant world
economic uncertainty advanced by OPV. fuel source in the mid-1950s. However, the burgeoning use
of oil has come at both a significant environmental and
Keywords conventional oil, price volatility, macroecon- economic cost, the latter in part reflecting the significant
omy, economic stability, energy security macroeconomic uncertainty associated with oil price
volatility (hereafter referred to as OPV).
OPV is defined as the standard deviation of oil prices in a
1 Introduction given period. The economic uncertainty generated by the
extreme volatility of oil prices has important consequences
Not long ago, anyone who had mentioned that the United for the global economy that differ markedly from the
States would likely become energy independent or would impacts of oil price shocks.1) While the economy-wide
have said that they could consider exporting fossil implications of oil price shocks as well as the upside and
downside potential in oil prices have been extensively
Received September 27, 2013; accepted November 18, 2013 studied, the literature examining the macroeconomic
effects of OPV remains relatively underdeveloped.
✉
Zoheir EBRAHIM, Oliver R. INDERWILDI ( ), David A. KING Through a comprehensive survey of the OPV literature,
Smith School of Enterprise and the Environment, University of Oxford,
Oxford, OX1 3QY, United Kingdom this paper highlights the fundamental concerns posed by
E-mail: [email protected] price volatility for the global economy and examines the

1) An oil price shock is a manifestation of extreme volatility. For the purposes of the present study, which focuses on oil price volatility as opposed to shocks, it
is reasonable to understand the distinction between both measures in terms of the size of price deviations. Acute deviations in oil prices, such as those seen in
early 2008 are termed shocks, while relatively minor price deviations are referred to as price volatility.
10 Front. Energy 2014, 8(1): 9–24

behavioral responses of macroeconomic agents to OPV, through the release of emergency oil stocks to markets [4].
with a view to highlighting the policy trade-offs involved This core energy security mechanism, which still remains
with minimising volatility and its associated economic the nucleus of the IEA today, requires that IEA member
risks. The results of this paper will inform the supply and countries maintain emergency oil reserves equal to the
demand-side priorities for policymakers who are faced value of 90 days of net oil imports so that the economic
with the challenging task of minimising adverse macro- repercussions of significant supply-side oil shocks can be
economic impacts associated with OPV. mitigated through their release. The US Strategic Petro-
The nature of oil prices changed fundamentally after the leum Reserve, which has the capacity to hold 727 million
1973 oil embargo by the Organisation of Arab Petroleum barrels of oil, is the largest such emergency reserve of
Exporting Countries (OAPEC). Prior to 1973, for instance, crude oil in the world [5]. However, while the IEA security
US oil prices displayed low volatility across broad time mechanisms provide an effective supply-side risk manage-
periods and approximated a step function, due to the ment solution, they are unable to entirely reduce OPV
distinct regulatory structure of the oil industry from 1948 because the supply of oil is characterized by significant
to 1972 in which state regulatory services such as the Texas inelasticity (vide infra) and because supply-side oil
Railroad Commission assigned permissible production disruptions only partially drive price volatility.
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, 2 Drivers of OPV
a characteristic that has increased sharply during the major
supply disruptions over the past four decades, and which Reflecting the status of oil as the most globalised
continues to typify the oil market today. Oil prices reached commodity, oil prices have historically exhibited greater
their historical high of $147 per barrel midway through levels of volatility than other commodities and asset prices
2008, only to drop sharply to below $40 per barrel by the [6]. There are three main drivers of OPV: characteristics of
end of the year. Such acute oil price deviations have oil market fundamentals, speculation in the oil derivatives
increased the vulnerability of the global economy to crises market, and inadequacies in oil market data.
by generating considerable economic uncertainty. Figure 1
depicts the average monthly nominal Brent Crude price 2.1 Characteristics of oil market fundamentals
(US dollars) and standard deviation from 1988 to 2013.
The inception of the International Energy Agency (IEA) The physical demand and supply of oil constitute the
in November 1974 was a direct response to the price fundamentals of the oil market. The short-run demand and
volatility impacts of the 1973–1974 OAPEC oil embargo. supply of oil are both strongly price inelastic [7], meaning
The foundational remit of this institution delineated its that marginal changes in either oil demand or supply
coordinative role in assisting member countries to issue a induce greater than proportional oil price changes and,
collective response to major disruptions in oil supply often, large price deviations. From a long-term perspective,

Fig. 1 Average monthly nominal Brent Crude price (US dollars) and standard deviation from 1988 to 2013
 Zoheir EBRAHIM et al. Macroeconomic impacts of oil price volatility: mitigation and resilience 11

growth in OPV has been primarily attributable to the responsive to changes in income than changes in prices
decrease in the price elasticities of both oil supply and [14].
demand since the mid-1980s [8]. Over the past decade, the Disruptions caused by political tension and conflict in oil
transition of both oil demand and supply toward a more producing regions have historically held the greatest
inelastic state has become particularly apparent. Despite weight in explaining the largest fluctuations in oil prices
the unprecedented demand-led growth in oil prices over [15,16], and evidence suggests that market participants
the 2003–2008 period, for instance, conventional crude oil continue to respond strongly to the potential for supply
production stagnated from 2005 to 2008 [9]. In contrast, disruptions in producing nations experiencing political
global oil demand, remained resilient, as increases in the turmoil. The 2011 Libyan Civil War and continuing
demand for oil in the BRICs and the Middle East, more geopolitical tensions centered around the Iranian nuclear
than offset decreases in the demand for oil in Western program, for example, have both placed significant upward
Europe and North America. pressure on oil prices [17].
The increasing inelasticity of oil supply has been fuelled However, the explanatory power of supply-side shocks
by several factors, most notably decreasing conventional has somewhat deteriorated over the past decade, because
oil production capacity and rates of new discovery, as well the largest producers are now undertaking significant
as blockages to new oil market investment. Infrastructural efforts to stabilize prices by offsetting decreasing regional
investment in the oil sector in Iraq, for example, has been supply with increasing production in other jurisdictions
more-or-less stationary over the past decade, reflecting a [18]. For instance, Saudi production levels reached their
significant investment risk due to political and national 30-year high in the first financial quarter of 2012 and were
instability. And while unconventional oil reserves are maintained at well above their average level throughout the
presently seeing increasing rates of exploitation in many year in an attempt to offset geopolitical tensions [19]. But it
countries around the world, slower production rates in is important to note that the potential for such supply
comparison to conventional reserves are significantly coordination is becoming significantly limited by the
reducing the pace at which producers are now able to growing domestic use of petroleum in producing countries.
respond to price changes [10]. More than a quarter of the oil produced in Saudi Arabia, for
Demand-side inelasticity has been primarily driven by example, is now consumed domestically, reflecting the
the decades-long structuring of the global economy around impact of extensive and institutionalised fuel consumption
oil, particularly in the case of the transportation sector, in subsidies, which have prevented domestic fuel prices from
which oil powered transit and associated infrastructure reflecting their true market value [20]. This means that
retains market dominance, despite the increasing popular- higher oil production will not immediately or necessarily
ity of alternatives such as electrically powered vehicles. translate into larger export availabilities.
This structural dependence on oil has been augmented by In addition to unprecedented producer efforts to stabilize
extensive and institutionalised fuel consumption subsidies prices, the IEA collective response mechanism has
in non-OECD countries, which have dampened substitu- markedly mitigated the potential for severe price volatility
tion effects and preserved oil demand at an artificially high on several recent occasions. The 2011 Libyan Civil War,
level [11]. for instance, saw IEA member countries release 60 million
In addition to the inelastic nature of both oil supply and barrels of oil to mitigate supply disruptions of Libyan light
demand, there are several specific supply and demand-side sweet crude. This markedly reduced tightness — the main
factors that aggravate OPV. Oil supply, for example, is drive of short-term OPV (vide supra) — in the prompt
vulnerable to unquantifiable sources of instability, such as supply of light sweet crudes [21].
regional conflict in producing areas, theft, and the On the demand-side, growing but steady patterns of oil
uncertainties raised by the nationalisation of oil companies, consumption in emerging economies (where demand
which can lead to significant disruptions in both invest- growth has been centered over the past decade) are equally
ment cycles and short-term supply availabilities. Global unable to account for intense swings in crude oil prices.
ratings agencies, for example, have pointed toward the Instead, a popular explanation of the fortification of OPV
potential for both growing regulatory and investment in recent years is that the progressive financialisation of the
uncertainty for foreign and domestic companies wishing to crude oil market has led to its transformation from a largely
invest in the Argentinian oil industry, following the physical market into a complex and predominantly
nationalisation of Yacimientos Petrolíferos Fiscales financial market [18].
(YPF) in 2012. The demand for oil, on the other hand,
exhibits cyclical tendencies and seasonality [12] so that the 2.2 Oil derivatives market and its price impacts
relationship between the demand for oil and real output is
procyclically contemporaneous [13]. Inherent business 2.2.1 Origins and purposes of the oil derivatives market
cycle volatility is thus also likely to make itself manifest in
oil prices. The relationship between oil prices and business After the damaging economic impacts of the 1973 oil
cycles is augmented by the fact that oil demand is more crisis, a consensus emerged acknowledging the critical
12 Front. Energy 2014, 8(1): 9–24

need for the creation of effective risk management time, and stand in opposition to historical oil price
mechanisms in the oil market, similar in utility and scope movements. Excluding episodic volatility, oil prices
to the contemporary risk management systems in foreign generally decreased over the 1980–2000 period. Factors
exchange markets. In response, a diverse set of financial such as technological change, political disruption, revised
instruments was adapted to allow oil industry actors to expectations relating to the availability of resources, and
effectively manage capital and diversify risk, becoming the structure of the global oil market, have all historically
collectively known as the oil derivatives market. Since its played a more significant role in dictating price trends [26],
inception, the oil derivatives market has grown exponen- reflecting the fact that the Hotelling model’s assumption of
tially in size and is now at least 14 times larger than the a perfectly competitive market failed to fit the structural
physical oil market [22]. Its precise dimensions are, form of the oil market. The oil production quotas imposed
however, difficult to gauge given the bifurcation of the over the 1982–1986 period by Organisation of the
market between regulated exchange-traded derivatives Petroleum Exporting Countries (OPEC), for example,
contracts and unregulated over-the-counter (OTC) deriva- represented a significant disruption to natural market
tives contracts. dynamics [27]. Moreover, such market disturbance was
With technological advancement, the range of financial augmented by the non-formulaic nature of OPEC produc-
tools available to investors has gradually expanded and tion ceilings [28]. In the view of the WTO, the market
increased in complexity, enabling new forms of transaction structure of non-renewable resources is thus better
and behavior to evolve in accordance with the market. characterized as imperfect [29]. But, providing that the
However, these new operations have increasingly diverged oil market becomes more transparent and less ‘imperfect’
from the raison d'être of the market. Oil derivatives were over time, this dynamic could change. The waning power
originally devised and intended to be used to guard and of OPEC, for example, has significantly reduced non-
hedge against the uncertainty generated by price volatility. competitive market pressures [30], and may provide an
But non-commercial investors have increasingly been explanation as to why with the exception of oil prices in
using oil derivatives for a different purpose all together: to 2009, the price trend over the 2003–2012 period followed
accept financial risk in exchange for prospective reward. the predictions presented by Hotelling’s rule.
Such speculative activity has been driven by the belief that In opposition to the predictions of the EMH, behavioral
exploitable inefficiencies exist in financial markets. economists emphasizse that herding behavior, which has
prevailed in the crude oil market [31–33], and human data
2.2.2 Efficient markets and Hotelling’s rule processing errors have created market inefficiencies,
leading prices astray. For example, increases in index
Building on earlier research which advanced the idea that fund flows have been found to accurately predict higher oil
the path of stock prices follows a random walk, Eugene futures prices three months later, while the flows of
Fama proposed in his efficient markets hypothesis (EMH) managed money spread positions have been shown to
that the informational efficiency of financial markets positively affect future oil prices [34]. Oil derivatives
renders it impossible to use price trends and information markets are now also displaying a strengthened relation-
to achieve consistently above average stock market returns ship with seemingly unrelated markets. For example,
[23]. Arbitrage — a riskless profit obtained through the despite sharing wholly different fundamentals, the cross-
simultaneous sale and purchase of an asset to take market correlations between West Texas Intermediate
advantage of price disparities [24] is thus unattainable if (WTI) Crude futures and the Euro Stoxx 600 and Standard
the EMH holds. For finite resources in particular, the and Poor’s Goldman Sachs Commodity Indexes (S&P
economic theorist Harold Hotelling argued that arbitrage is GSCI) have evolved from displaying approximately no
impossible [25]. According to Hotelling’s rule, the net correlation to a near perfect correlation over the course of
price of a non-renewable resource such as oil, should rise at the past decade [17,34,35]. Such developments suggest a
the market interest rate in a purely competitive market non-fundamentals based explanation of OPV.
equilibrium, in order to reflect the appreciation in the value
of exhaustible resources as reserves are depleted. 2.2.4 Speculation as a driver of price volatility

2.2.3 Market inefficiencies A large body of evidence suggests that speculative activity
has divorced oil prices from solely reflecting developments
However, all available evidence suggests that both the in market fundamentals on specific occasions. The
EMH and Hotelling’s rule, with respect to the crude oil increased volatility and upshot in crude oil prices during
market, have not been held in reality, due to the various the 1990–1991 Persian Gulf War, for example, occurred
inefficiencies that characterize the crude oil market(vide with no analogous alteration in oil supply. Price develop-
infra). The main prediction of Hotelling’s rule that oil ments during this period, instead, solely reflected uncer-
prices should be characterized by an upward trend over tainty [36]. In addition to their price impact during the
 Zoheir EBRAHIM et al. Macroeconomic impacts of oil price volatility: mitigation and resilience 13

1990–1991 Persian Gulf War, speculative demand shocks However, while the initiative has made much progress on
were a critical determinant of the volatility in oil prices in improving data transparency, results are not yet optimal
1979 (following the Iranian Revolution), in 1986 (follow- because data submission rates by member countries have
ing the collapse of OPEC) and in 1997–2000 (following been declining for the past three years. Moreover, the
the Asian financial crisis) [16]. However, current evidence timeliness of data submissions remains inconsistent,
(vide supra) related to new cross-market correlations creating additional uncertainty [38]. The JODI database
suggests a systemic increase in the price volatility impacts is also not subject to external review and does not cover the
of speculation quite apart from the outlier impacts of data relating to oil reserves [39]. While this data is
speculation during exceptional oil market episodes over published by several independent sources, non-uniformity
the past decades. With financial investors providing the in the reporting of both volumes and grades places the
key link between unrelated markets, previously intangible accuracy of such estimates under considerable ambiguity
volatility spillovers from the stock market to the oil market and, moreover, restricts direct comparability [40]. The
and vice versa, appear to have been institutionalised. IEA, for example, incorporates natural gas liquids, refinery
Furthermore, the dominance of herd behavior in the oil feedstocks and additives in its definition of crude oil; all of
derivatives market as the market has expanded [18], has which are excluded in the definition of crude oil employed
compounded existing volatility associated with market by the Energy Information Administration (EIA). Non-
fundamentals, through the amplification of upswings and standardised data collection and reporting methods, are the
downswings already implied by movements in physical norms across a range of physical oil market variables, the
market demand and supply, as high frequency and short- corollary being sizeable variations in market forecasts
term trading positions have gained in popularity and across different agencies. A forecast disparity amounting
increased in financial significance. Such complex interplay to approximately 30 million barrels per day exists, for
between speculative activity in response to developments example, between IEA and OPEC forecasts of cumulative
in market fundamentals and activity based on recent price oil demand up to 2035 [41]. Such data deficiencies drive
trends rather than market fundamentals has added to the volatility by hindering the formation of accurate medium
diverse set of conflicting factors within the oil market and to long-term price expectations. Countering inadequacies
created a self-sustaining source of price volatility. pertaining physical market data thus requires greater
While there are still significant academic divisions international and institutional collaboration to ensure
regarding the precise impact of speculation on volatility homogeneity in data collection, variable definitions,
(partly reflecting disparities in the methodology and time coverage and statistical representations, and may also
periods considered in the causal analyses of volatility), the require an expansion in coverage to include more diverse
impact of speculation on volatility appears to be relatively and underappreciated market variables. For example,
muted in comparison to other market factors. In his improved coverage of oil tanker traffic could be useful in
analysis of the drivers of the oil price shock of 2007–2008, providing an alternative measure of production.
for example, James D. Hamilton concluded that while the In addition to the informational deficit in the physical oil
flow of speculative investment influenced the ‘miscalcula- market, opacity and non-uniformity in both regulatory
tion’ of oil prices in 2008, the stagnation of production standards and coverage characterize several variables of
since 2005 together with highly inelastic demand had interest in the oil derivatives market. Publishing of the
greater explanatory power [37]. categorisation and positions of traders, for example, is not
a constitutional requirement on the main European bourse
2.3 Inadequate market data trading in oil derivatives, the Intercontinental Exchange,
Inc. (ICE), whereas the disclosure of this information is
Herd behavior is, in part, precipitated by inadequacies in mandatory for participants on the New York Mercantile
the transparency, accuracy, and availability of critical oil Exchange (NYMEX). But despite differing national
market data, including inventories and estimations of regulatory structures, identical derivatives contracts are
current and future quantities of oil demand, supply, traded internationally; the WTI Light Sweet Crude Oil
production, stocks, and reserves. Uncertainties regarding contract, for example, is common to both ICE and
such variables have impacted OPV by shifting the NYMEX.
information sources that guide investment decisions from
relatively inaccessible but pertinent oil market data to
accessible yet comparatively uninformative trends in 3 Effects of OPV
recent oil prices [6].
The joint organisations data initiative (JODI) was 3.1 Asymmetrical response of macroeconomic activity to
specifically created to address the link between OPV and oil price changes
the opacity of oil market information. Its core institutional
aim is to improve the accessibility and accuracy of oil “Oil prices have fallen lately. We include this news for the
market data in order to moderate excessive price volatility. benefit of gas stations, which otherwise wouldn’t learn of it
14 Front. Energy 2014, 8(1): 9–24

for six months.”1) counterbalancing influences and moderating responses can

One reason that the volatility of oil prices matters offset some of the economic effects of OPV discussed thus
fundamentally more in terms of economic output than the far. This section explores the viability of such responses to
level of oil prices is that OPV has been found to amplify examine whether OPV will necessarily lead to a decline in
the asymmetrical response of economic activity to oil price the constituent elements of aggregate demand and supply,
changes — a phenomenon first documented by the econ- in the short, medium, and long-term. This analysis will
omist Knut Anton Mork [42]. Mork’s findings show that help to clarify the trade-offs involved with minimising
oil price increases have a proportionally greater (and price volatility and inform section 7 of this paper, which
negative) impact on economic activity than the corre- focuses on the priorities and areas of focus for policy-
sponding positive economic impact of oil price decreases. makers who are faced with the task of minimizing the
The intensification of the asymmetrical economic output adverse macroeconomic impacts of OPV. Figure 2
response to oil price changes under OPV has since been illustrates the direct and indirect responses to OPV.
confirmed by several national studies of the impact of OPV
on macroeconomic variables [43–49]. 4.1 Direct responses to OPV

3.2 Literature survey OPV directly impacts three primary macroeconomic

channels: consumption, investment, and industrial produc-
Literature examining the link between OPV and economic tion [43,46–54]. The precise extent to which these
activity strongly suggests that OPV negatively affects variables are affected is dependent on two factors: the
economic output in the short to medium-term [43–57]. degree of uncertainty generated by OPV; and the attitudes
Adverse short-term economic impacts largely reflect the of economic agents to uncertainty. Hereafter, the possible
deterioration of aggregate demand as OPV intensifies. responses of consumers, investors, and producers to OPV
Aggregate consumption and investment, for example, are analyzed in order to understand the optimal policy
immediately decrease in response to the economic response(s) to OPV.
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 4.1.1 Consumption
decline in the short-run [43,52,53,57], production declines
are more likely to be a response to downward trends in Declining consumer demand under OPV [46,49–51,58]
aggregate demand than to production cost uncertainty. This reflects the fact that the uncertainties advanced by OPV,
is because industrial producers respond to production/input regarding future income and employment prospects,
cost uncertainty by raising product prices to incorporate an decrease consumer confidence [60] and prompt consumers
uncertainty premium, rather than by reducing production to adopt precautionary savings behavior at the opportunity
levels [59]. In the medium-term, aggregate supply is more cost of current consumption [49,58]. This confirms the
responsive than aggregate demand to the effects of OPV. principal prediction of precautionary savings literature that
This is foremost the product of decreasing investment in by reducing the average propensity to consume (the
the short term which results in constrained production percentage of income spent rather than saved) greater
capacity and increased supply-side inelasticity in the economic uncertainty should result in declining aggregate
medium-term. Other negative economic effects of OPV consumption [61–64]. In the medium-term, volatility-
in the medium-term such as inflation [48,56,57,59], are driven unemployment [50,54] augments downward pres-
also likely to stem from supply-side responses to OPV; the sures on aggregate consumption by increasing consumer
aforementioned uncertainty premium, for example, pre- pessimism regarding future economic prospects and
cipitates increasing inflation. reinforcing existing precautionary savings motives [64].
Economic models, such as Hall’s random-walk model of
consumption, also suggest that by increasing the uncer-
4 Responses to OPV tainty about future income, OPV should increase the
stochasticity (randomness) of consumption [65].
The literature survey has indicated that the occurrence of
certain events is probable in the precarious economic 4.1.2 Investment
environment created by OPV; inflation and unemployment
are both likely to increase, while investment, stock market Because investment is most responsive in areas where
returns, consumer demand, and industrial production are consumer demand is either resilient or expected to grow,
likely to decrease. However, under certain circumstances, the effects of OPV on aggregate consumption have a

1) William Tammeus, The Globe and Mail (Toronto), 1991

 Zoheir EBRAHIM et al. Macroeconomic impacts of oil price volatility: mitigation and resilience 15

Fig. 2 Direct and indirect responses to OPV

significant impact on investment decisions. Real options preferences between investors in financial and real
valuation literature suggests that, due to the uncertainties markets, as well as the differences in the quality of risk
relating to the profitability of investment in a volatile compensating mechanisms in financial and real markets,
energy environment, the benefits of holding a more risk financial investment may be positively correlated with
averse investment portfolio outweigh the future advantages OPV. Stock market returns, for example, may necessarily
gained from current commitments to irreversible invest- appreciate during periods of acute OPV, as investors
ment expenditures [66,67]. Evidence of decreasing demand higher risk premiums [72] to compensate for
aggregate investment as a result of OPV [47,50,51,68– increased investment risk [71]. Furthermore, while fre-
71] suggests that firms do indeed optimise their investment quent price deviations increase the chances of financial
expenditures in this fashion and that, parallel to the loss, such deviations also shape perceived opportunities for
attitudes of consumers under OPV, investors are risk- arbitrage. Thus, one consequence of OPV may be the
averse. This commonality is in part driven by the fact that deterrence of risk-averse investors and the attraction of
investment is determined by expected trends in consumer risk-loving investors to financial markets. The degree to
demand. In other words, the deterioration of aggregate which volatility is detrimental or beneficial to stock market
consumption as a result of OPV has a negative bearing on investment is thus a function of the prevailing risk
current investment decisions by leading to the downwards preference in financial markets at any given time. In a
revision of future demand expectations [49]. Additionally, risk-loving market, stock market investment can realisti-
stochastic consumption [65], in conjunction with the cally increase alongside OPV.
increased unpredictability of marginal production costs The negative relationship between real investment and
under OPV, has been found to significantly deter OPV is, additionally, only specific to the short and
investment by amplifying the uncertainties related to medium-run and disintegrates in the long-run, reflecting
future demand (and, hence, investment profitability). the fact that further delays to investment are subject to an
However, as a result of differences in aggregate risk increasing opportunity cost over time, as the strategic effort
16 Front. Energy 2014, 8(1): 9–24

to establish market share through commitment to new industrial producers attach to the prices of their goods
technologies acquires greater importance [71]. In the long- under production cost uncertainty. The high inflation rates
run, therefore, aggregate investment will recover to pre- throughout the 1970s can thus arguably be largely
volatility equilibrium levels, regardless of the extent of attributed to the sharp increase in OPV which occurred
price volatility in the market. Moreover, price volatility over the decade [48,59]. From this point of view, inflation
may actually drive increasing investment in the long-run if may be interpreted as a ‘necessary evil’ in maintaining
the volatility-induced switch in household behavior from industrial production levels under OPV. The source of
consumption to precautionary savings in the short to inflation, however, remains crucial in determining whether
medium-run enlarges the pool of savings available for the impact of inflation on industrial production is positive
funding investment [49,58]. or negative. If high energy prices are the cause of inflation,
a negative correlation should characterize the relationship
4.1.3 Industrial production
between industrial production and inflation, because higher
energy prices imply an increase in production costs and a
Industrial production generally declines in response to corresponding reduction in profitability. Rising energy
aggregate price volatility [73], but the essentiality of oil as prices during the first half of 2012, for example, boosted
an input into industrial processes means that OPV has an US Consumer Price Index (CPI) inflation while weighing
especially adverse effect on industrial production growth heavily on US factory output [74]. On the other hand, if
[43,52,53,57]. Although the time horizons considered in inflation is the product of an expansionary monetary policy
investment and production level planning differ markedly, response to OPV, industrial production is likely to be
the central determinants of investment (expected con- positively correlated to inflation.
sumption and returns) are also common to industrial While supply-side responses to OPV create inflationary
production. The decrease in industrial production as OPV pressures, demand-side responses, such as lower con-
increases is a response to the expected decreases and sumption and investment expenditure (vide supra), create
increased unpredictability of consumption as well as deflationary pressures. These opposing deflationary and
production and delivery cost uncertainty, vide supra. inflationary pressures carry different weights over different
However, unlike the predetermined negative relation- time periods and give rise to the U-shaped term structure of
ship between aggregate investment and OPV in the short inflation under OPV. In the short-run, inflationary
term [71], industrial production levels may be maintained pressures created by supply-side responses to production
in the short term despite of the uncertainty created by price cost uncertainty are likely to outweigh the deflationary
volatility, reflecting the differing production cost risk- pressures created by demand-side expenditure shifts,
management mechanisms commonly used by industrial because of the lag before which consumers are able to
producers and investors: contrary to the investor response form accurate expectations of how OPV will affect both
of delaying expenditure as production cost uncertainty the future economic outlook and the future level of
increases, industrial producers maintain production levels inflation [75]. Consumers, therefore, do not immediately
by increasing product prices to incorporate an uncertainty adjust expenditures downwards in response to OPV. In the
premium in order to compensate for increased production medium-term, however, deflationary pressures created by
cost uncertainty [59]. reduced demand-side expenditure are likely to outweigh
inflationary supply-side pressures, as fully formed inflation
and growth expectations reduce consumption and force a
4.2 Indirect responses to OPV proportional decrease in production levels. In the long
term, inflationary pressures are likely to accumulate as the
The impact of price volatility on consumer, investor, and decline in investment expenditure in response to OPV in
producer behavior, strongly influences both the level of the short to medium-term [71] reduces production capacity
inflation and the level of unemployment within oil and increases supply-side inelasticity.
dependent economies [48,50,53–56,58]. This section Changes in inflation expectations strongly influence the
explores the extent to which inflation and unemployment orientation of monetary policy. OPV exacerbates the
may indirectly increase in the short, medium, and long- traditional policy dilemma faced by monetary policy
term as a result of OPV, the relationship between inflation, authorities of lowering interest rates to directly promote
unemployment and OPV, and the extent to which monetary economic growth (accommodative policy) or raising
policy can effectively regulate both the inflationary and interest rates to limit inflation (tight policy), by creating
deflationary pressures of OPV. inflationary pressures and simultaneously lowering eco-
nomic activity [48]. This conflicting policy choice is likely
4.2.1 Inflation and monetary policy to be fluid and responsive to business cycles as well as to
the overall condition of the domestic economy.
Inflation is a natural by-product of the premium that In low-inflation economies, monetary policy authorities
 Zoheir EBRAHIM et al. Macroeconomic impacts of oil price volatility: mitigation and resilience 17

have more flexibility to pursue an output target, due to the 4.2.2 Unemployment
greater capacity of low-inflation economies to sustainably
absorb further inflation. Therefore, in a low-inflation The increasing rate of unemployment under OPV
environment, monetary policy authorities have a stronger [51,54,80] is precipitated by the decline in both industrial
incentive to focus on supporting consumption, investment, production and overall economic activity as OPV
and production through expansionary monetary policy intensifies [43–57]. In periods of excessive OPV, an
rather than limiting inflation through contractionary increase in the rate of unemployment occurs because the
monetary policy. In addition to its beneficial impact on industrial workforce in the short to medium-term is more
real investment, such a monetary policy response implies likely to wait in anticipation production level restoration
that financial investment could increase regardless of OPV, (and commensurate job opportunities in the industrial
because a decrease in the interest rate (which represents the sector) than to retrain for jobs that require alternative skill
applied discount rate in the calculation of the current value sets [81–85].
of companies), should result in an increase in the value and The extent to which unemployment is affected by price
share returns of stock market-listed companies [24]. Such volatility depends on the contribution of the industrial
conditions could feasibly precipitate an increase in sector to GDP and the structure of labor market laws. OPV
financial investment, as investors rush to benefit from a is likely to lead to higher unemployment in economies in
market in which stock returns are appreciating. which the industrial sector holds a fundamental place in the
However, such a simplistic view of monetary decision- sectoral composition of economic growth, than in
making does not account for the role of expectations in economies in which the industrial sector plays a compara-
determining the effectiveness of policy. A significant risk tively less important role. This explains why OPV has had
posed by the use of expansionary monetary policy to boost such a significant impact on the rate of unemployment in
consumption, investment, and production under OPV, is the US [50,81] (the world’s second largest industrial
the creation of a liquidity trap. The liquidity trap as producer), but relatively muted unemployment-impacts in
formulated by John Maynard Keynes in his General service-based economies [86]. The structure of labor
Theory of Employment, Interest and Money [76], refers to a market laws also play a crucial role in determining the
situation in which the approach of the nominal rate of extent to which adverse industrial production and
interest toward zero fails to reverse the preference for consumption under OPV are translated into higher
saving. Since the nominal rate of interest cannot be unemployment. Over the past decade, government invol-
negative, conventional monetary policy ceases to be vement in labor markets has decreased substantially in
effective in stimulating the economy when the nominal most OECD countries; however labor market structures
interest rate reaches zero. The Japanese economy in the late within the OECD are still characterized by significant
1990s remains the most prominent example of this heterogeneity. The increase in unemployment under oil
scenario [75], however, the low interest rates in European OPV in countries characterized by flexible labor markets
economies and the US over the past two years, which have including Estonia, Poland and the UK, is thus likely to be
failed to substantially increasing bank lending or consumer more severe than in countries with limited labor market
demand, also imply the existence of a wide-scale modern- flexibility such as Belgium, France, Italy and Spain [87].
day liquidity trap [77]. OPV directly increases the risk of a The rigidity of unemployment levels in countries with less
liquidity trap by adversely affecting consumer confidence flexible labor markets may also explain the trade-off
[49,58,60]. In an environment in which low consumer between inflation and unemployment implied by the short-
confidence pervades, the cheaper availability of money is run Phillips curve.
unable to overturn the precautionary savings behavior of
consumers, which OPV encourages [49,58] This bottle- 4.2.3 Stagflation
neck has two fundamental implications for the future
direction of monetary policy: the management of OPV In the 1970s, the negative relationship between the rate of
should lie beyond the remit of monetary policy; and inflation and the rate of unemployment, graphically
monetary policy should be more conservative. This represented by the Phillips curve, ceased to hold.
reflects the fact that the necessarily forward-looking or Unemployment and inflation, instead, rose in conjunction
pre-emptive nature of monetary policy [78], is ill-suited in with one another in several countries, while economic
addressing short-term price volatility. Moreover, despite growth was either stationary or declining, a condition
the fact that the term-structure of inflation under price known as stagflation. The finding that OPV both increases
volatility is predictable, price volatility itself is difficult to inflation and unemployment and decreases economic
predict. A less conservative expansionary monetary growth, suggests that OPV also pushes the economy into
policy approach may unintentionally augment the a stagflationary mode. The stagflation that pervaded the
inflationary pressures created by price volatility because 1970s can arguably thus be largely attributed to the
of the limitations involved in the forecasting of significant increase in OPV which occurred over the
OPV [79]. decade.
18 Front. Energy 2014, 8(1): 9–24

5 Dependency on crude oil and financial 22% in 2003. This reflects a greater reliance on oil imports
implications to fulfil domestic demand since the peak in UK oil
production in 1999 [88], which ultimately shifted its
In the context of the increase in oil prices and price position from being a net exporter to a net importer of oil in
volatility which has occurred over the past decade, the 2005 [89]. In contrast to the low oil prices faced by British
global dependency on crude oil has serious financial oil exporters in the zenith of the UK oil export market in
implications; chiefly, trade deficits are now foremost the the 1990s, the position of the UK from 2005 onwards as a
result of expenditure allocated to crude oil imports (Fig. 3). net oil importer coincided with the upward trend in oil
Expenditure devoted to crude oil imports as a percentage prices beginning in 2003. The upward trend in oil prices
of the trade balance has significantly increased in the over the past decade also explains why expenditure on
majority of OECD countries over the past decade, despite imported crude oil has increased in countries where oil
declining consumption. Crude oil import expenditure imports have been declining. Despite the decline in US
represented 86% of the UK trade deficit in 2011, up from crude oil imports since 2006, for example, expenditure on

Fig. 3 Expenditure on imported crude oil as a percentage of the trade balance

 Zoheir EBRAHIM et al. Macroeconomic impacts of oil price volatility: mitigation and resilience 19

imported crude oil represented 65% of the US trade deficit reversion to its old currency — the Drachma — comes at
in 2011, up from 36% in 2006. the cost of a significant devaluation. According to certain
Such adverse pressure on trade balances will worsen in estimates, reversion to the Drachma would see Greece
oil-importing countries over the coming decades as the spending almost three times more on crude oil imports
price of oil continues to increase. By 2035, the IEA [94]. A visualization of the hypothetical increase in oil
estimates that nominal oil prices will reach $215 per barrel. import expenditure under the Drachma in the event that
According to the IEA, the US is also likely to approach Greece exits the Eurozone compared to the value of the
energy self-sufficiency by 2035 [90]. But this does not Drachma when Greece first joined the Eurozone, is
imply that pressure on the US trade balance, as a result of presented in Fig. 4.
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 6 Key messages
domestic US oil prices are, after all, dictated by global
market forces [91]. Thus, the possibility of future US Price volatility in the crude oil market is increasing at a
energy self-sufficiency does not eliminate the macroeco- faster rate than volatility in other commodity markets,
nomic problems created by the increasing trend in oil partly due to the status of oil as the most globalised
prices; it merely alters the specific framing of the problem. commodity.
In contrast to both the UK and the US, Germany has There are three main drivers of OPV: tightness, or the
successfully maintained a trade surplus throughout the past highly inelastic nature of both supply and demand, in the
decade, due to the vitality of its export sector [92], and its crude oil market; speculation in the oil derivatives market;
expenditure on imported crude oil as a percentage of the and inadequacies in oil market data.
trade surplus has plateaued in recent years. However, this While improvements in the quality and transparency of
expenditure trend masks significant concerns for future oil market data will be important in lessening the extent of
German economic sustainability. Since 1995, German future price volatility, most of the price volatility that has
import dependency with regard to both crude oil and occurred over the past decade reflects market tightness and
natural gas liquids (NGL) has remained above 93% [93]. speculative activity in the oil derivatives market. Realign-
And despite the fact that the expenditure devoted to ing the use of the oil derivatives market toward its initial
imported crude oil as a percentage of the German trade purpose (hedging) will be fundamental in managing future
surplus has stagnated over the past decade, Germany is still price volatility.
spending a substantial proportion of its trade surplus to The uncertainty advanced by OPV has damaging and
finance domestic oil consumption. In 2011, for example, destabilizing macroeconomic effects. The high degree of
29% of its trade surplus was used to finance oil imports. OPV which has characterized the market for the past four
Such acute import dependency can be hazardous in the decades represents a fundamental barrier to stability and
event of a negative economic shock. For example, Greek hence growth. The management and reduction of price
expenditure on imported crude oil, which already con- volatility will play a key role in enhancing stability in
stitutes an enormous proportion of the Greek trade deficit future economic growth trajectories, vide infra.
(77% in 2011), would increase unsustainably in the event Policies to reduce price volatility must be balanced
that Greece exits the Eurozone. This is because the between the prevention and the cure of OPV.

Fig. 4 Greek expenditure on imported crude oil under the old and new Drachma
20 Front. Energy 2014, 8(1): 9–24

Preventative policy should center around the stabiliza- future market stability. One possibility might be the
tion of oil supply. The IEA collective response to the Libya legislative requirement that companies and industries
crisis in June 2011, which saw member countries release which are heavily reliant on oil powered production
60 million barrels of oil to mitigate the ongoing supply processes, should maintain individual strategic oil reserves
disruption of Libyan light sweet crude, effectively reduced to provide effective insulation from price volatility.
the potential severity of price volatility. Cooperation and Supply-side risk management policies are important but
concerted action of this kind will be fundamental in at best can only minimise OPV and its associated
mitigating future price volatility. macroeconomic effects. Macroeconomic isolation from
The solution or ‘cure’, however, will be intrinsically OPV can only be achieved through a combination of
linked to demand-side policies focused on reducing the supply and demand-side policies. Demand-side policy
global reliance on oil, achieving greater diversification in should prioritise strategies that reduce oil dependency,
the global energy mix and increasing energy efficiency. In such as disincentivising oil consumption through tax and
contrast to the antiquate adage, the cure is better than the subsidy reform, improving sectoral energy efficiency and
prevention, because the instability and inelasticity of oil facilitating greater diversification in the global energy mix.
supply (the primary drivers of volatility) will only worsen Institutionalised oil price subsidies in non-OECD countries
over the coming decades as the quantity of conventional oil have augmented the global structural dependence on oil
reserves diminishes. and provided little incentive for lowering oil consumption
Finally, future research needs to focus on the quantifica- [11]. An important initial policy step would be the review
tion and forecasting of OPV to allow policy makers to of national energy subsidy policies to assess the areas in
effectively prepare appropriate risk-management response which there is greatest scope for both subsidy and tax
mechanisms to address price volatility. 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
7 Policy interventions energy efficiency must be all centered around innovations
in the transportation sector. Fuel taxes have raised
Price volatility is primarily driven by supply-side factors consumer awareness about the fuel economy of vehicles
but mainly has demand-side impacts. Policy to reduce and have been particularly effective in improving fuel
price volatility and its associated adverse macroeconomic economy and reducing vehicle emissions in the European
effects must therefore encompass both supply-side and Union [95]. However, several strategies to improve energy
demand-side solutions. The primary focus of supply-side efficiency in the transportation sector including the
(preventative) policy should be the stabilization of oil adoption of fuel-economy standards and the construction
supply because the largest increases in price volatility have of codes and requirements for greater efficiency in power
historically arisen from supply-side oil disruptions. To an plants, have been restricted by poor government organiza-
extent, the market is self-correcting in this regard. tion [96]. Significant political will is thus required to
Production practices from the largest oil producers in achieve effective policy reform related to energy efficiency
order to stabilize prices, such as the increased production standards. Governments must also play a role in creating a
levels in Saudi Arabia during the first half of 2012 to offset facilitating environment in which a diversified set of
geopolitical tensions [19], suggest that oil producers are alternative and renewable sources of energy can thrive.
concerned about the adverse long-term demand-side Part of this role includes the re-alignment of financial
impacts of sustained high oil price intervals and are industry in order to increase its contribution toward the
unwilling to tolerate both high prices and volatility in the funding of alternative energy sources [97]. Alternative
market. Despite this, the IEA projects that, nominal oil fuels that have the potential to be used in the transportation
prices will reach at least $215 per barrel by 2035 [90]. sector, including algae derived fuels [98], natural gas [99],
Global cooperation and concerted action will thus be hydrogen [100], and decarbonised electricity [101], all
fundamental in the management and reduction of future require significant financial backing before they can
price volatility. In this regard, the IEA collective action become economically viable.
framework, which mandates the maintenance of strategic Finally, the significant growth and impact of speculation
oil reserves, has recently been highly effective on several on price volatility over the past decade has highlighted the
occasions in reducing the extent of price volatility in the necessity of policies that constrain the misuse of the oil
context of oil-supply disruptions. The IEA collective derivatives market. The European Commission’s proposed
response to the 2011 Libya crisis, for example, which saw Financial Transactions Tax, which has the backing of ten
member countries release 60 million barrels of oil to countries and is expected to come into force in 2014, is
mitigate the ongoing supply disruption of Libyan light unlikely to be adequate in tackling speculation on the oil
sweet crude, effectively reduced the potential severity of derivatives market for two reasons: the proposed tax,
price volatility[21]. Strengthening and expanding IEA and which is estimated to be levied at 0.01% for derivatives
analogous systems will thus be important in enhancing transactions, is too small [102]; and the tax will not
 Zoheir EBRAHIM et al. Macroeconomic impacts of oil price volatility: mitigation and resilience 21

differentiate between speculators and hedgers and is thus weights of the inflationary and deflationary pressures
only likely to increase the cost of hedging without created by OPV over time. In response to the decline in
specifically tackling speculation [103]. To effectively industrial production, investment and consumption, unem-
gauge and address speculative activity, policies to improve ployment also significantly increases under OPV. But the
the systems of identification of traders and their respective precise extent to which unemployment is affected by price
positions are necessary so that regulators are better able to volatility will depend on the contribution of the industrial
manage speculative activity. This may necessitate the sector to GDP and the structure of labor market laws. The
adoption of an American style model in European trading finding that OPV both increases unemployment and
exchanges. The mandatory classification of traders and inflation and decreases economic growth suggests that
their respective positions — an already institutionalised OPV pushes the economy into a stagflationary mode. The
feature on NYMEX — could, for example, be exported to stagflation that pervaded the 1970s can arguably thus be
the ICE. Additionally, improvements in the general quality largely attributed to the significant increase in OPV that
and transparency of both physical and financial oil market occurred over the decade.
information would lessen market uncertainty and price A combination of supply-side and demand-side policies
volatility by improving the accuracy and homogeneity of aimed at preventing and providing a solution to OPV is
price expectations. Strengthening and expanding the scope vital if stability in future economic growth trajectories is to
of oil market information and assessment systems such as be achieved. An expansion of systems that mandate global
Latest Energy, Metals & Steel News, Market Data and cooperation and concerted action in oil supply chain
Analysis (PLATTS) and JODI by instituting policies to management, such as the IEA collective action framework,
improve consistency and reliability in data submissions is is necessary in order to minimise short-term price volatility
thus essential in lessening future 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
8 Conclusions realigning the use of the oil derivatives market away from
speculation and toward its initial purpose: hedging.
The high degree of OPV that has characterized the market Improving derivatives market regulatory systems and
for the past four decades represents a fundamental barrier working toward international derivatives regulatory stan-
to economic growth, due to its damaging and destabilizing dards will be vital in achieving this goal but efforts to curb
effects on the macroeconomy. Through the generation of speculation so far have been lacklustre. While a step in the
economic uncertainty, OPV adversely impacts aggregate right direction, the European Commission’s proposed
consumption, investment, and industrial production, Financial Transactions Tax, which is expected to come
resulting in an indirect ripple-through impact on aggregate into force in 2014, is unlikely to be adequate in curbing
unemployment and inflation. Uncertainties pertaining to speculation and its effects on oil prices because of the
future income streams under OPV decrease consumer relative size of the tax (0.01% for derivatives transactions)
demand while increasing the randomness of consumption. and the lack of differentiation between speculators and
This prompts the decrease of physical investment expen- hedgers in the tax structure. Instead, the tax may simply
diture in both the short and medium-term. However, as the disincentivise hedging behavior at a time when hedging is
pool of savings available for investment expands, greater vital. In the medium and long-term, the main task of
aggregate investment is facilitated in the long term. Short- governments should be to create a facilitating environment
term financial investment, in contrast, may increase in which incentivises infrastructural investments and the
response to OPV (depending on the degree of risk production of a diversified set of alternative renewable
preference which characterizes the financial market at fuels that can be used as a substitute for oil, particularly in
any given time) reflecting risk premium revision and the transportation sector. Complementary to this are
perceived opportunities for financial gain as price devia- demand-side management policies to reduce the global
tions increase. Industrial production is also adversely structural dependence on oil. Part of this role will require
affected under OPV, due to the impact of price volatility on the politically challenging task of energy subsidy and tax
consumer demand and production costs. However, because reform to incentivise the consumption of alternative fuels
production cost uncertainty can be offset through price and disincentivise oil consumption, particularly in non-
increases, OPV only guarantees declining industrial OECD countries where oil price subsidies have been
production in the short-run if its effect on consumption is institutionalised. But a significant opportunity in reducing
greater than its impact on production costs. the demand for oil is also to be found in policies that are
The effects of OPV on consumer, investor, and producer aimed at improving energy efficiency such as the adoption
behavior, strongly influence both the level of inflation and of fuel-economy standards and the construction of codes
the level of unemployment within economies affected by and requirements for greater energy efficiency in various
OPV. Under OPV, the term-structure of inflation is likely to sectors of the economy.
correspond to a U-shape, in reflection of the relative It has not escaped out attention that the research
22 Front. Energy 2014, 8(1): 9–24

presented herein strongly suggest that the significant 15. Namboodiri P K S. Politics and economics of oil prices. Strategic
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