Transmission mechanisms of geopolitical risks to the crude oil market——A pioneering two-stage geopolitical risk analysis approach

Abstract

As an exogenous risk, geopolitical risk drives oil price volatility indirectly through multiple factors, which are ignored by most studies. This paper establishes a two-stage approach for the first time to analyze the indirect geopolitical risk transmission mechanisms, and applies the time-varying parametric vector autoregressive (TVPVAR) model to illustrate how geopolitical risk affects oil prices via different transmission paths including micro media (supply, demand, inventories, speculative behaviors) and macro media (global economic activities). Oil prices do not always rise in response to geopolitical events, sometimes even varies to the opposite direction, a phenomenon that can be well explained and modeled by the transmission mechanisms we developed. In this paper, we have identified two clear and unique geopolitical transmission paths to enhance energy-related decisions. Aside from the conventional economic phenomenon of geopolitical risks affecting oil prices through supply and demand behaviors, speculative behaviors increase during the period of high geopolitical risk, and the impact of speculative activity on oil prices is prominent. In addition, the most influential path is that geopolitical factors can indirectly impact oil prices by influencing economic fluctuations, which provides powerful and empirical supports for energy-related financial decisions and policy implications.