The Ephemeral Brent Geopolitical Risk Premium

Abstract

We study the changing relationship between Brent oil prices and geopolitical risk, conditional on physical oil market conditions. We conduct the analysis at three frequencies, medium (1-3 years), high (2-3 months), and very high (daily), using three complementary techniques at the different levels (respectively, continuous wavelet partial coherence, VAR and GARCH-MIDAS) over the period April 1993 to the end of 2018. At the annual frequency, we find evidence of a sustained positive relationship between oil prices and geopolitical risk over the past decade -- with geopolitical risk leading during the Arab Spring, resulting in a substantial geopolitical risk premium, and lagging thereafter by about two months, as oil markets first reacted to and then anticipated geopolitical events. At the monthly frequency, we find the same positive correlation with oil prices anticipating geopolitical risk in both parts of the sample and find that realized geopolitical strife has not led to higher prices in either subsample. At the daily frequency, we find that geopolitical risk has had a positive effect on oil price volatility in later days during the second half of the sample (2005 to 2018). Our findings suggest that some financial market speculators, such as macro hedge funds and algorithmic traders, may amass long positions in Brent in anticipation of geopolitical threats that might potentially lead to oil disruptions.