OPEC’s Risk Premia and Volatility in Oil Prices

Abstract

This paper discusses a reason for volatility in oil prices. The Organization of Petroleum Exporting Countries’ (OPEC’s) revenues are positively correlated with macroeconomic activity. Being procyclic, volatility would not seem to benefit OPEC. However, using instruments to sort out endogeneity of OPEC’s revenues with respect to macroeconomic activity, volatility originating with oil prices is countercyclical in the U.S. and Europe, and OPEC, therefore, can command a risk premium. The risk premium may incentivize OPEC to destabilize prices, which lowers macroeconomic output because of the asymmetric effects of oil prices on the macroeconomy. While variation in OPEC’s revenues originating with the macroeconomy was positively correlated with the macroeconomy, OPEC’s revenues are extremely insensitive to macroeconomic activity. As a result, in any conventional model of risk, OPEC can also command a risk premium when volatility originates with the macroeconomy.