Macroeconomic Uncertainty and Oil Price Volatility
| DOI | http://doi.org/10.1111/obes.12124 |
| Date | 01 October 2016 |
| Published date | 01 October 2016 |
| Author | Ine Van Robays |
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©2016 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd.
OXFORD BULLETIN OF ECONOMICSAND STATISTICS, 78, 5 (2016) 0305–9049
doi: 10.1111/obes.12124
Macroeconomic Uncertainty and Oil Price
Volatility*
Ine Van Robays
European Central Bank, Sonnemanstrasse 20 60314, Frankfurt am Main Germany
(e-mail: ine.van-robays@ecb.europa.eu)
Abstract
This paper shows that higher macroeconomic uncertainty causes higher oil price volatility.
Regimes of low and high uncertainty are identified in a threshold VAR model in which
the effects of structural oil demand and supply shocks are estimated. The results show that
higher macroeconomic uncertainty, as measured by global industrial production volatility,
significantly increases the sensitivity of oil prices to shocks in oil demand and supply. This
occurs as uncertainty lowers the price elasticity of oil demand and supply. The difference
in the estimated oil price elasticities is economically meaningful as the price impact of a
similar change in oil production might double when it hits the economy in uncertain times.
As such, varying uncertainty can explain why oil price volatility is typically higher during
periods such as financial crises and recessions, and why oil price volatility changes over
time more generally.
I. Introduction
Oil price volatility is not constant over time.After being historically low for several years,
oil price volatility spiked in the period surrounding the financial crisis and the European
sovereign debt crisis.Also more recently, limited changes in oil demand and supply caused
oil prices to drop considerably. Periods of strong oil price volatility tend to spark intensive
debates in the literature on the possible drivers (e.g. Hamilton, 2009a; Kilian and Murphy,
2014; Singleton, 2014). Variation in oil price volatility is however not a new phenomenon;
oil price volatility has been subject to substantial fluctuations since the early 1970s (see
Figure 1). As oil price volatility by itself can negatively affect economic activity (Jo,
2014), understanding its determinants is important. This paper explores whether higher
macroeconomic uncertainty causes oil price volatility to be higher.
There are two general explanations why oil price volatility changes over time. First,
periods of elevated oil price volatility can simply be caused by large oil shocks. In the
1970s, for example, large shocks to oil supply explainedmost of the high oil price volatility
JEL Classification numbers: E31, E32, Q41, Q43
*I am grateful to the editors, the two referees, Ron Alquist, Hilde Bjørnland,Thier ry Bracke, Gerdie Everaert and
Gert Peersman for useful comments and suggestions and to Nathan Balke for sharing his codes.
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6-month rolling stdv 12-month rolling stdv
Figure 1 Real oil price volatility over time
Notes: Oil price volatility is measured by the 6-month and 12-month rolling standard deviation of the oil price.
Units are in standard deviations. The oil price used is the realWTI cr ude oil whichhas been deflated with US
CPI (1982–84=100) and backcasted using the growth rate of the refiner acquisition cost of US imported oil in
growth rates.
observed during that period (Hamilton, 2009a). A second explanation of higher oil price
volatility is that oil prices can become more sensitive to variationin oil demand and supply.
For the same change in the demand or supply of oil, the reaction of the oil price is stronger.
This occurs when the price elasticity of oil demand and supply is lower, i.e. when the
sensitivity of oil demand and supply to oil price changes is reduced. For example, if oil
demand reacts less to an oil supply shock, the price response is magnified as there is
less adjustment through the quantity side. As such, a lower price elasticity of oil demand
increases oil price volatility.
It has been shown that the price elasticity of oil demand and supply is important to un-
derstand oil price volatility. For example, Baumeister and Peersman (2013a) have demon-
strated that a significant drop in the price elasticity of oil demand and supply caused a
systematic increase in oil price volatility since the mid-1980s. Since then, similar changes
in oil demand and supply had larger effects on oil prices compared to before. Also in
relation to the global financial crisis, it has been stressed that low price elasticities are
essential to explain the strong price fluctuations observed during that period (Hamilton,
2009a; Lipsky, 2009; Smith, 2009).
This paper is the first to empirically analyse whether macroeconomic uncertainty in-
creases oil price volatility by lowering the price elasticity of oil demand and supply. I show
that macroeconomic uncertainty indeed significantly alters the sensitivity of oil prices to oil
demand and supply shocks and thereby acts as an additional transmission channel through
which the price impact of oil demand and supply shocks is reinforced.
There are several reasons why uncertainty might lead to higher oil price volatility. One
possible and widely documented channel is that uncertainty changes the decision-making
behaviour of economic agents (Bernanke, 1983; Pindyck, 1991; Litzenberger and Rabi-
nowitz, 1995; Bloom, Bond and Van Reenen, 2007). When uncertainty is high and shocks
hit the economy, the adjustment in quantities is constrained due to a delay in the production
©2016 The Department of Economics, University of Oxford and JohnWiley & Sons Ltd
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