The shale revolution, geopolitical risk, and oil price volatility

Abstract

The U.S. shale revolution, using new technologies to extract crude oil, has led to new dynamics in the supply side of the global oil market. We ask whether the shale revolution has dampened the role of geopolitical risk in oil price volatility. We extend a reduced form Structural Break Threshold Vector Autoregressive (SBT-VAR) model to a structural SBT-VAR model and identify the structural innovations by allowing conditional heteroskedasticity. Compared with the conventional reduced form VAR and TVAR models, an SBT-VAR with a constant threshold and a break in April 2014 are supported by the data. We then analyse the conditional (co)variance impulse response concerning two distinct shock scenarios, one with only a geopolitical risk shock, and the other with a simultaneous shale production shock and a geopolitical risk shock. The volatility responses are due to the identified contemporaneous relationships amongst geopolitical risk, shale production and oil prices, and are conditional on volatilities at the points in time. With the extra unit shale production shock, we find that the volatility response of oil prices to a geopolitical risk shock is higher, but the response is less correlated with the geopolitical risk factor.