Volatility Relationship between Crude Oil and Petroleum Products

By Lee, Thomas K.; Zyren, John | Atlantic Economic Journal, March 2007 | Go to article overview
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Volatility Relationship between Crude Oil and Petroleum Products


Lee, Thomas K., Zyren, John, Atlantic Economic Journal


Introduction

The daily price of West Texas Intermediate (WTI) crude oil has shown a six-fold variation in recent years, ranging from a low of $10.82 in December 1998 to a high of $69.91 in August 2005. During the year 2005, consumers paid the highest nominal gasoline prices ever. The high levels and rapid fluctuations of petroleum prices have become a great concern to individual consumers, firms, policy makers and society. However, traditional price theory in economics, which determines an equilibrium price by balancing supply and demand, may not fully explain the current price behavior of crude oil and petroleum products. For example, according to the International Energy Agency (IEA), the annual growth rate of demand for petroleum products in North America has been 1.3% since the year 2000, while during the same time period, the world-wide growth rate in supply for these products was 2%, which would indicate substantial downward pressure on prices.

From the producers' point of view, volatility, whether persistent or transitory, discourages fixed capital investment due to uncertainty of the price path, and it encourages firms to hedge underlying assets against price shocks. From the traders' point of view, increasing price volatility of a commodity invites an arbitrage opportunity in the market since a volatility measure is a key determinant for derivative valuation. These various perceptions and interpretations of the price volatility by different groups lead us to review two basic questions. First, what is the volatility behavior of petroleum prices and what is its relationship in the spot and futures markets? This question will guide us in a comparative analysis of price volatility among different markets. It is well known that, because of the relatively high storage costs for crude oil and its products, inventory shocks tend to affect short-term price fluctuations in petroleum markets more than other commodity markets. Second, are these volatilities persistent or transitory, and what is the magnitude of the volatility? If the volatility is large and persistent, it may lead firms to rely more heavily on hedging operations and other types of risk management and to place more emphasis on the evaluation of investments in the context of uncertainty. Thus, it is imperative to understand the volatility behavior, its magnitude and duration, as well as its implications. This paper is unique because it compares price volatility for crude oil and petroleum products over a long period of time in both the spot and futures markets.

A volatility study of energy markets by Pindyck (2004, p. 18) concluded that changes in volatility are short-lived with a half-life of 5 to 10 weeks and that volatility has a small positive time trend, which implies little impact on firms' investment activities or on the economy. However, his model did not incorporate structural breaks that have occurred in petroleum markets. In order to shed light on the aforementioned two questions, this paper proposes three hypothesis concerning the behavior of volatility in petroleum markets:

1. Crude oil and petroleum product volatility is larger due to the new OPEC pricing regime. We suspect that higher price volatility in petroleum markets in recent years is due to the change in the Organization of Petroleum Exporting Countries' (OPEC) crude oil pricing behavior in March 1999.

2. Price volatility of petroleum products is larger than that for crude oil. We expect the gasoline and heating oil markets have higher price volatility since, in addition to price changes in conjunction with the raw material (crude oil) price, they have their own set of market factors affecting price and volatility.

3. Price volatility for near futures contracts is larger than that for more distant futures contracts. Since the spot price and near futures markets for commodities are much more affected by new information, rumors, and catastrophic events than are the more distant futures contracts, we would expect volatility to decrease as contract length increases.

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