How Do Political Tensions and Geopolitical Risks Impact Oil Prices?

Abstract

This paper assesses the effect of US-China political relationships and geopolitical risks on oil prices. To this end, we consider two quantitative measures—the Political Relationship Index (PRI) and the Geopolitical Risk Index (GPR)—and rely on structural VAR and local projections methodologies. We expand the literature on the macroeconomic consequences of geopolitical risks by considering bilateral political relationships. The bilateral GPR does not focus on the relation between the US and China; rather, it provides an overall picture of the geopolitical uncertainty for China on a multilateral basis. Our empirical investigation shows that improved US-China relationships, as well as higher geopolitical risks, drive up the price of oil. Indeed, unexpected shocks in the political relationship index are associated with optimistic expectations about economic activity, whereas unexpected shocks in the geopolitical risk index reflect fears of supply disruption. Political tensions and geopolitical risks are thus complementary causal drivers of oil prices, the former being linked to the demand side and the latter to the supply side.

Keywords: oil prices, political relationships, geopolitical risk, China

JEL Classification: Q4, F51, C32