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| Fig. 1: Crude Oil Prices 1900-2014. [8] (Courtesy of British Petroleum) |
Oil and energy markets, essential as they are to a functioning economy, also prove to be extremely volatile. In fact, prices for crude oil, refined petroleum, and natural gas are more volatile than prices of 95% of other commodities. [1] This has largely been the case since the 1970s, when the 1973 oil crisis sent a deep shock to the price of oil, as can be observed in Fig. 1. It is important to note that volatility encompasses what may be seen as positive developments, such as decreases in price, and negative developments, such as price increases caused by shortages. While volatility may occasionally have positive aspects, uncertainty surrounding price fluctuations means it is something that is most businesses and governments aim to avoid. Since 1986, global nominal oil prices have risen from $8.7 to $145.7, with a standard deviation of $25.7. [2] To avoid the instability, there are diverse measures in place that various institutions employ.
Government controls on oil and energy prices typically come in the form of price freezes or ceilings for increasing prices rather than price floors, given that price decreases are typically politically popular to consumers. In 2007 and 2008, before and during the Global Financial Crisis, prices and volatility increased substantially, causing many governments to put in place freezes as crude prices first surpassed $100 per barrel and approached $140 per barrel. [3]
Another government tactic for controlling price increases and volatility are price subsidies and tax reductions. These tactics have been substantial in recent years, with many countries spending billions per year on subsidies or tax reductions. Indonesia, for example, committed $6.7 billion to energy subsidies in May 2018. [4] Governments may also target specific industries with subsidies and tax reductions to reduce costs. These industries often include agriculture, public and goods transport, and fisheries, to avoid consumers receiving substantial price shocks to essential purchases.
Other countries employ price stabilization funds, which function by setting domestic prices higher than international prices when prices are low and using the proceeds to lower prices when prices rise more sharply than expected. In practice, the fact that oil prices are consistently rising limits the effectiveness of these funds and their ability to smooth prices. Moreover, these controls can be politically unpopular by forcing consumers to pay more than the international prices, even when prices are low.
A final strategy that some countries employ is the build up of strategic oil reserves. The United States, for example, had 665.1 million barrels of oil in its Strategic Petroleum Reserve in February 2018. [5] These reserves make it possible for these countries to supply the market in the case of sharp price spikes that typically result from physical disruptions to supply, such as hurricanes and other natural disasters. When used correctly, strategic reserves can be incredibly valuable, but critics have chided politicians for attempting to use the reserves for political purposes, as some speculate Bill Clinton did in 2000 to combat rising oil prices. [3]
While some of these controls may be politically popular by keeping prices lower and more stable, they may also create challenges, including supply shortages and underinvestment in the energy sector, in addition to oil companies suffering losses when they sell their refined products at lower prices than the crude they purchased. Ultimately, it may be the case that a shift away from oil to other energy sources is the most certain way to avoid the high level of volatility.
While governments have powerful pricing tools at their disposals when it comes to controlling prices for short periods of time, individual businesses have more limited options, which most often involve price smoothing. Most in need of these tools are companies with large fuel expenses, such as airlines, shipping lines, and transportation companies. The need for such products was made clear in 2008, when Northwest CEO, Doug Steenland, testified that U.S. airline carriers were on track to spend "$61.2 billion on jet fuel [that] year, $20 billion more than in 2007, and [were] projected to incur losses totaling close to $10 billion". [3] Companies most often turn to hedging oil prices through forwards, futures, and options, which allow them to lock in either a certain cost or a range of costs in order to avoid massive fluctuations. [6] While there is the possibility of losing out on savings if fuel prices drops, financial markets far prefer to avoid the uncertainty and can gain greatly by hedging. In fact, unusually aggressive hedging practices by Southwest Airlines allowed the company to save more $455 million in 2004, $892 million in 2005, $675 million in 2006 and $439 million in the first nine months of 2007, during a period of increasing prices. [7] Providers of futures contracts often include fuel management companies, oil companies, financial institutions, and utilities providers with teams specializing in the industry.
© Carlos Ezquerro. The author warrants that the work is the author's own and that Stanford University provided no input other than typesetting and referencing guidelines. The author grants permission to copy, distribute and display this work in unaltered form, with attribution to the author, for noncommercial purposes only. All other rights, including commercial rights, are reserved to the author.
[1] E. Regnier, "Oil and Energy Price Volatility," Energy Econ. 29, 405 (2007).
[2] J. E. Rentschler, "Oil Price Volatility, Economic Growth and the Hedging Role of Renewable Energy," World Bank, Policy Research Working Paper 6603, September 2013.
[3] R. McNally, Crude Volatility: the History and the Future of Boom-Bust Oil Prices (Columbia University Press, 2017).
[4] T. Diela and G. Suroyo, "Indonesia Will Shield Public From 'Big Shock' as Oil Prices Kump - Fin Min," Reuters, 21 May 18.
[5] T. Gardner, "U.S. Budget Deal Would Sell 15 Percent of Emergency Oil Reserve," Reuters, 8 Feb 18.
[6] E. Noordeh, "Energy Derivatives," Physics 240, Stanford University, Fall 2017.
[7] J. Bailey, "Southwest Airlines Gains Advantage by Hedging on Long-Term Oil Contracts," New York Times, 28 Nov 07
[8] "BP Statistical Review of World Energy 2018," British Petroleum, June 2018.