Oil Prices and Long-Run Risk

Abstract

I show that relative levels of aggregate consumption and personal oil consumption provide an excellent proxy for oil prices, and that high oil prices predict low future aggregate consumption growth. Motivated by these facts, I add an oil consumption good to the long-run risk model of Bansal and Yaron [2004] to study the asset pricing implications of observed changes in the dynamic interaction of consumption and oil prices. In the model, oil prices are implied by the agent’s rst order condition, and expected consumption growth is driven by two distinct factors: the oil price and a separate predictable component of growth. Empirically I observe that, over the rst half of my 1987 - 2010 sample, increases in these factors predict high future oil consumption growth. More recently, I observe that expected oil consumption growth has no response to either factor. The model predicts that this change in consumption dynamics implies changes in risk which generate a hump shaped term structure of oil futures, consistent with recent data. Additionally, the model predicts a change in the conditional relation of aggregate consumption volatility, oil price volatility, and the term structure of oil futures. I also nd evidence for this in the data. Finally, the model implies that the change in the dynamics of oil consumption implies increased systematic risk from oil price shocks, but reduces the risk from shocks to expected consumption growth. The combined eect is to reduce overall consumption risk and lower the equity premium.