Volatility of Oil Prices

WP/96/82-EA

Volatility of Oil Prices by Peter Wickham


This paper examines crude oil prices from 1980 to mid-1996, focusing
specifically on two episodes of high volatility: the oil price slump in
1986 linked to the changeover to market-determined pricing from the system
of administered prices, and the surge in prices in 1990 resulting from the
Iraqi invasion of Kuwait. To help examine certain aspects of oil price
volatility, a generalized autoregressive conditional heteroscedastic model
(GARCH), which allows the conditional variance to be time-variant, is
estimated.

The difference between the two oil price situations was reflected in
prices for spot oil and oil futures on the New York Mercantile Exchange.
The 1986 price slump, associated with uncertainty over how long increasing
supplies and ample stocks would persist, resulted in early 1986 in a price
path for futures contracts that was positively sloped, with contracts
further into the future commanding a premium.

In contrast, the 1990 episode of exceptionally high prices, reflecting
the disruption of supplies and pressure on crude oil stocks outside the
Middle East, caused spot and prompt supplies to trade at a premium, with
further out contracts trading at a significant discount as traders expected
resolution of the Kuwaiti conflict and regularization of supplies.

The analysis brings out several important features about the dynamic
behavior of oil markets and oil prices. First, it is possible to carry
forward current supplies in the form of stocks, but only to a limited extent
in the short run is it possible to shift or bring forward large volumes of
supply from the future. Second, except for physical limits in the short run,
it is possible (at a cost) to carry forward supplies (hold stocks) without
being otherwise constrained. On the other hand, because stocks cannot
effectively be negative, prices can rise very sharply for spot and prompt
deliveries when supply disruptions occur and stocks are relatively low, even
if the supply disturbance is not viewed as long term.