An introduction to oil market volatility analysis

• Date: 01 September 2013
• Author: Axel Pierru,Saud M. Al‐Fattah,Tarek Atallah,Walid Matar
• Published date: 01 September 2013
• DOI: http://doi.org/10.1111/opec.12007

An introduction to oil market

volatility analysis1

Walid Matar,* Saud M. Al-Fattah,** Tarek Atallah*** and Axel Pierru****

*Sr.Research Analyst, Energy Research, King Abdullah Petroleum Studies and Research Center

(KAPSARC), Riyadh, Saudi Arabia

**Fellow, Energy Research, King Abdullah Petroleum Studies and Research Center (KAPSARC), PO Box

88550, Riyadh 11672, Saudi Arabia. Email: saud.fattah@kapsarc.org

***Sr.Research Analyst, Energy Research, King Abdullah Petroleum Studies and Research Center

(KAPSARC), Riyadh, Saudi Arabia

****Fellow, Energy Research, King Abdullah Petroleum Studies and Research Center (KAPSARC), Riyadh,

Saudi Arabia

Abstract

Modelling and forecasting crude oil price volatility is crucial in many financial and investmentappli-

cations. The main purpose of this paper is to reviewand assess the cur rent state of oil market volatil-

ity knowledge. It highlights the properties and characteristics of the oil price volatility that models

seek to capture, and discuss the different modelling approaches to oil price volatility.Asymmetric

response to price change, persistence and mean reversion, structural breaks, and possible market

spilloverof volatility are discussed. To complement the discussion, West TexasInter mediate futures

price data are used to illustrate these properties using non-parametric and conditional modelling

methods. The generalised autoregressive conditional heteroskedasticity-type models usually

applied in the oil price volatility literature are also explored.We additionally examine the exogenous

factors that may influence volatility in the oil markets.

1. Introduction

As crude oil plays a major role in global economic activity, understanding the volatility

of its price is of paramount importance. For risk managers, oil price volatility impacts

hedging and the assessment of projects whose cash flows are influenced by the expected

price of the commodity. Long-term uncertainty in future oil prices can alter the incen-

tives to develop new oil fields in producing countries. This can also hinder the imple-

mentation of alternative energy policies in consuming countries. In the short term,

volatility can affect the demand for storage, as greater volatility should lead to increased

storage demand, spot prices and the marginal convenience yield.2Last but not least,

volatility is a key variable in the pricing of derivatives whose trading volume has signifi-

cantly increased in the last decade. In all of these applications, it is essential that some

level of predictability can be captured when modelling oil price volatility.

247

©2013 King Abdullah Petroleum Studies and Research Center (KAPSARC). OPEC Energy Review published by John

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This is an open access article under the terms of the Creative Commons Attribution License, which permits use,

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[The copyright line for this article was changed on 20 November 2017 after original online publication].

Previous reviews of price volatility (e.g. Engle and Patton, 2001; Poon and Granger,

2003) have not specifically dealt with the crude oil price. Studying oil markets, Sadorsky

(2006) compared the performance of different classes of models and their attributes. We

extend on the literature by conducting a reviewof the general proper ties of price volatility

and how they applyto the oil markets, provide an updated look at the models applied to oil

prices, and explore exogenous factors that could be included in those models.The proper-

ties and modelling approaches are also demonstrated by the analysis of historical West

TexasIntermediate (WTI) prices.

In words, volatility refers to the degree to which prices fluctuate. It is not directly

observable and is estimated from the change in price; therefore, the return on price will be

discussed in the second section to lay the foundation for the subsequent sections. In

Section 3, the various approaches to modelling volatility in the oil markets are detailed.

The stylised properties of volatility are explored in Section 4, as it is important to consider

their presence when developing forecasts. We build on the model discussion by studying

how each approach attempts to account for these properties. In order to form a comprehen-

sive model, Section 5 examinesthe exter nal factors that mayimpact the volatility of the oil

price.

2. Crude oil price returns

2.1. Return and volatility: tworelated concepts

Volatility is typically quantified as the standard deviation3of price returns. This section is

therefore focused on the basic properties of returns, or relative price changes, and the

resulting insight regarding volatility.For the computation of volatility, the return on price

is commonly determined in continuous time. Given a time scale Dt, which could range

from seconds to months, the standard definition of the price return r(t,Dt) is then

derived by,

Pt e Pt t

rt t

()

=−

()

()

,ΔΔ(1a)

Where P(t) is the price of crude oil at t. Hence,

rt t Pt

Pt t

,lnΔΔ

()

=

()

−

()

⎛

⎝

⎜⎞

⎠

⎟(1b)

For illustrative purposes, Figures 1 and 2provide the daily and monthly returns on

WTI first-month futures price, respectively. The price data is observed from 27 May1987

to 12 October 2011.4The daily returns have been adjusted for intermediate non-trading

days—weekends and holidays—following the procedure suggested by Pindyck (2004)

Walid Matar et al.248

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OPEC Energy Review publishedby John Wiley & SonsLtd on behalf of Organization of the PetroleumExporting Countries.