Author Information : Lin Gao, University of Luxembourg
Steffen Hitzemann, Rutgers Business School
Ivan Shaliastovich, University of Wisconsin-Madison
Lai Xu, Syracuse University
Year of Publication : The Journal of Financial Economics (Forthcoming)
Summary of Findings : The option-implied oil price volatility is a strong negative predictor of economic growth beyond traditional financial and macroeconomic uncertainty measures.
Research Questions : 1: Empirically, can oil volatility predict output, consumption, investment, and other macro-economic growth variables? Oil sector growth variables? Financial Markets?
2: Which model can reconcile these empirical findings?
In this paper, we consider a component of economic uncertainty associated with the volatility of oil prices. In the data and in the macro-finance model with an oil sector and a general macro sector, we document that forward-looking oil price variance stands out among other financial and macroeconomic uncertainties as a strong and robust indicator for the aggregate economy, the oil sector, and financial markets. Our two-sector model features stochastic supply uncertainties in both sectors. In times of high oil-related uncertainty, firms in oil sectors increase their inventories as a cushion to potentially large negative oil supply shocks. As a result of this precautionary savings effect, the amount of oil used for production in the general macro sector is reduced, which depresses output, consumption, investment, and employment.
What we know : Recent research underscores an important role of fluctuations in economic uncertainty for the macroeconomy and financial markets. The large and growing literature in this area commonly finds that measures of aggregate macroeconomic, equity market, and policy uncertainty negatively predict economic growth several quarters ahead and are a central driver of asset prices. Further, uncertainties related to specific sectors, sources, or markets play an important role beyond aggregate macro and stock market volatilities.
Novel Findings : Empirically, we first show that a rise in option-implied oil variance predicts a decline in current and future output, consumption, investment, and employment. The effects are significant up to four quarters ahead, and up to twelve quarters excluding the Financial Crisis. Quantitatively, the predictive effects of oil volatility are equally strong, and often times stronger than of the other traditional measures of aggregate uncertainty, such as the implied variance of equity prices, the variance of total factor productivity (TFP), or the policy uncertainty measure of Bloom et al. (2018). We do not find any evidence that oil volatility predicts a decline in future productivity. On the other hand, an increase in oil variance predicts a significant increase in oil inventories (or decrease in oil basis) and a parallel decline in oil consumption. Next, our results show that aggregate equity valuations have strong negative exposures to oil volatility at quarterly, annual, and longer-term frequencies. In the cross section of industries, the asset price exposures to oil volatility exhibit a distinct pattern: industries with negative exposures to oil price risk tend to have negative oil variance betas. At the other end of the spectrum, the oil industry is one of the sectors with the least negative (or even positive) exposure to oil price and oil variance risks.
Motivated by the empirical evidence, we develop a macro-finance model with an oil sector and a general macro sector, featuring stochastic supply uncertainties in both sectors. In the oil sector, oil is extracted from existing wells, and the aggregate extraction rate is subject to exogenous fluctuations. On the other side, oil is used in the general macro sector as an essential input for final goods production. Firms rationally manage oil inventories to mitigate the consequences of oil supply fluctuations and decide at each point in time how much oil to hold in storage, which determines how much oil can effectively be used for the production of final goods. In times of high oil-related uncertainty, they increase their inventories as a cushion to potentially large negative oil supply shocks. As a result of this precautionary savings effect, the amount of oil used for production in the general macro sector is reduced, which depresses output, consumption, investment, and employment.
Full Citations : Gao, Lin, Steffen Hitzemann, Ivan Shaliastovich, Lai Xu, Oil Volatility Risk, The Journal of Financial Economics (Forthcoming)
Abstract : The option-implied oil price volatility is a strong negative predictor of economic growth beyond traditional financial and macroeconomic uncertainty measures. A rise in oil volatility also predicts an increase in oil inventories and a reduction in oil consumption, in line with a propagation channel through the oil sector. We explain these findings within a macro-finance model featuring stochastic uncertainties and precautionary oil inventories: firms increase oil inventories when oil volatility rises, which curbs oil use for production and depresses economic activity. In the model and the data, aggregate equity prices fall at times of high oil volatility, with differential exposures across economic sectors.