The effectiveness of crude oil futures hedging during infectious disease outbreaks in the 21st century

• Published date: 01 November 2023
• Author: You‐How Go,Jia‐Jun Teo,Kam Fong Chan
• Date: 01 November 2023
• DOI: http://doi.org/10.1002/fut.22447

Received: 3 May 2022

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Accepted: 11 June 2023

DOI: 10.1002/fut.22447

RESEARCH ARTICLE

The effectiveness of crude oil futures hedging during

infectious disease outbreaks in the 21st century

You‐How Go

1

|Jia‐Jun Teo

1

|Kam Fong Chan

2

1

Faculty of Business and Finance,

Universiti Tunku Abdul Rahman, Perak,

Malaysia

2

School of Business, The University of

Western Australia, Perth, Australia

Correspondence

You‐How Go, Faculty of Business and

Finance, Universiti Tunku Abdul

Rahman, Perak, Malaysia.

Email: goyh@utar.edu.my

Abstract

This study analyzes the hedging effectiveness of crude oil futures during

infectious disease outbreaks in the 21st century. The conditional volatility of

crude oil markets experienced a greater shock during the coronavirus disease

2019 (COVID‐19) pandemic than during the severe acute respiratory

syndrome and swine‐origin influenza A outbreaks. The sharp decline in the

conditional correlation of crude oil markets following the onset of COVID‐19

increases the persistence of shocks to correlations, thereby diminishing the

effectiveness of futures contracts as a hedging instrument.

KEYWORDS

COVID‐19, crude oil futures, H1N1, hedging effectiveness, SARS

JEL CLASSIFICATION

G10, G11, G12, G13

1|INTRODUCTION

Disease outbreaks pose a significant risk to global health, financial markets, the economy, and global commodities.

Among the major commodities, crude oil is particularly susceptible to the economic impacts of disease outbreaks,

predominantly due to disruptions in exploration and production processes (Kaminski, 2014). The spillover effects of

such market disruptions have a significant effect on the derivatives market, and this in turn could reduce the

effectiveness of derivatives in hedging price risk. These negative impacts underscore the need for hedgers, speculators,

and other market participants to consider the implications of disease outbreaks on commodity markets, particularly in

the case of crude oil, when developing and implementing hedging strategies.

This study examines the hedging effectiveness of crude oil futures amid disease outbreaks. The outbreak of disease

provides an ideal setting to study the performance of crude oil hedging in turbulent times. The unpredictability of

disease outbreaks can lead to sudden shifts in asset volatility, and price correlation between spot and future markets.

Given that the effectiveness of hedging depends on the variance and covariance of both spot and futures contracts, it is

an empirical question whether the hedging effectiveness of crude oil futures during normal period extends to

nonnormal “extreme”periods, such as disease outbreaks.

In this study, we focus on the following research questions:

(1) How does the persistence of shocks during disease outbreaks affect the conditional volatility of crude oil markets?

(2) How do disease outbreaks affect the correlations between spot and futures crude oil returns?

(3) How do disease outbreaks impact the hedge ratio?

(4) How do disease outbreaks affect the effectiveness of crude oil futures hedging?

J Futures Markets. 2023;43:1559–1575. wileyonlinelibrary.com/journal/fut © 2023 Wiley Periodicals LLC.

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We consider three crude oil markets, namely, West Texas Intermediate (WTI) crude oil traded on the New York

Mercantile Exchange, Brent crude oil traded on the London Intercontinental Exchange, and Oman crude oil traded on

the Dubai Mercantile Exchange. These highly liquid markets are widely regarded as the primary crude oil pricing

benchmarks for the United States, Europe, and Asian markets, respectively (Kaminski, 2012; Robe & Wallen, 2016).

Our analysis focuses on three notable disease outbreaks in the 21st century: the severe acute respiratory syndrome

(SARS) outbreak, the swine‐origin influenza A (H1N1) outbreak, and the coronavirus disease 2019 (COVID‐19)

outbreak. These disease outbreaks are typically associated with significant shocks in various economic sectors, such as

transportation and tourism, and disrupt the crude oil supply and demand.

1

We summarize the key findings of our analysis as follows. First, we examine the impact of persistence of shocks on

the conditional volatility of crude oil markets amid disease outbreaks. Following Park and Switzer (1995), Chang et al.

(2011), and others, we use two specifications to separately characterize the dynamics of spot and futures returns on

crude oil: the constant conditional correlation generalized autoregressive conditional heteroskedasticity (CCC‐

GARCH) model of Bollerslev (1990), and the dynamic conditional correlation GARCH (DCC‐GARCH) specification of

Engle (2002). Our empirical analysis shows that shocks to volatility during disease outbreaks have a long memory, and

are more persistent during the recent COVID‐19 pandemic than the earlier SARS and H1N1 outbreaks.

Further analysis indicates that during the COVID‐19 outbreak, shocks to the conditional correlation between spot and

futures markets are also highly persistent, particularly for WTI. Moreover, the correlation estimate (implied by the DCC‐

GARCH model) between spot and futures returns at the onset of the COVID‐19 outbreak was low, indicating that crude oil

markets responded positively to the COVID‐19 emergency when World Health Organization (WHO) declared COVID‐19 as a

global pandemic in March 2020. The dynamic conditional correlation (DCC) estimate for Brent (WTI) then progressively

(rapidly) approaches unity. In terms of model adequacy, we find that the DCC‐GARCH model outperforms the CCC‐GARCH

model in capturing the volatility dynamics of crude oil spot and futures returns, especially for the Brent and WTI markets.

Concerning optimal hedge ratios, the average hedge ratio estimates implied by the CCC‐GARCH and DCC‐GARCH

models during the H1N1 pandemic are closer to one. Since the H1N1 outbreak and the 2008–2010 global financial crisis

occurred concurrently, it is plausible that market participants experienced increased capital constraints, thereby

increasing their demand for futures hedging during the period of the twin crises. We also find that the hedge ratios for

all the crude oil markets were more volatile during the recent COVID‐19 outbreak relative to other outbreak periods.

Notably, the effects of the COVID‐19 pandemic on crude oil volatility are more enduring than those of SARS and H1N1,

which may have contributed to the high variation in hedge ratios. We also repeat the hedge ratio analysis on an

intermittent “nonoutbreak”period that occurs between the H1N1 and COVID‐19 outbreaks. The result is mixed:

relative to the nonoutbreak period, the hedge ratio estimates for WTI crude oil (Oman crude oil) were significantly

lower (higher) during the COVID‐19 pandemic, indicating different risk perceptions for both crude oil markets.

The final analysis entails evaluating the futures hedging effectiveness, which measures the degree of variance

reduction (VR) in a hedged position relative to an unhedged (spot) position (Ederington, 1979). Somewhat surprisingly,

there is no compelling evidence that the more highly parameterized DCC‐GARCH model outperforms the CCC‐

GARCH model in reducing the volatility of crude oil prices during disease outbreaks. The DCC‐GARCH model reduces

portfolio volatility more than the CCC‐GARCH model in five out of eight scenarios considered, including for Brent

during SARS and H1N1, and for WTI during SARS, but it performs poorly in reducing the volatility of WTI crude oil

returns during the H1N1 and COVID outbreaks, and Brent crude oil returns during the COVID outbreak.

Our study contributes to the extensive empirical literature analyzing crude oil price volatility during extreme periods. Van

Dijk et al. (1999), Ng and McAleer (2004), Charles (2008), Toyoshima et al. (2013), Lahmiri (2017), Joo et al. (2020), and

Zavadska et al. (2020) show that crude oil prices are highly volatile and exhibit infrequent shocks during crises, such as the

Asian financial crisis and the 2008–2010 global financial crisis. In crude oil, equity, and real estate assets, Chan et al. (2011)

provide evidence of a tranquil regime during economic expansions, and a turbulent regime during economic recessions.

Albulescu (2020)showsthatCOVID‐19 daily cases of new infections have a negligible impact on long‐term crude oil prices,

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During the recent COVID‐19 outbreak, a prolonged period of national lockdown and the shutdown of the manufacturing sector in the majority of

countries have also contributed to imbalances in oil production and consumption. Interestingly, Cheng et al. (2021) find that abrupt changes in

international oil prices are associated with both the H1N1 and COVID‐19 pandemics. A Bloomberg report attributes the slowdown in China's jet fuel

demand growth to the SARS outbreak (https://www.bloomberg.com/news/articles/2020-01-29/oil-data-from-sars-era-offers-clues-to-impact-of-

china-outbreak#xj4y7vzkg). According to the Australian Treasury, the fuel growth slump in China has a negative effect on the economic growth of a

number of East Asian nations, particularly in the first quarter of 2003 (https://treasury.gov.au/publication/economic-roundup-winter-2003/the-

economic-impact-of-severe-acute-respiratory-syndrome-sars).

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