Does Oil Market Volatility Earn OPEC a Risk Premium?

Abstract

The question is examined whether OPEC is in a position to collect a risk premium to effectively insure others against a macroeconomic downturn, which may, in turn, result from a rise in the price of crude oil. Contingent exchange is modeled such that parties whose consumption is elastic with respect to aggregate consumption hedge; they pay risk premia to smooth consumption. Parties whose consumption is inelastic or negatively related to aggregate consumption collect risk premia. OPEC’s revenues are estimated, insofar as they are explained by OPEC’s cartel pricing, to be strongly negatively related to aggregate consumption. Insofar as they are explained by exogenous macroeconomic changes, they are highly inelastic with respect to the aggregate. Either way, OPEC is in a strong position to collect a risk premium from volatility in the market for crude oil. This may incent it to destabilize the market, which would lower macroeconomic output because of the asymmetric effects of oil prices on the macroeconomy.

Keywords: OPEC; risk premium; volatility; crude oil; asymmetric

JEL Classification: Q43