metadata: authors: 0: author: Baffes,John
1: author: Kshirsagar,Varun
count: World
docna: 0: docna: Sources of volatility during four oil price crashes
docty: Policy Research Working Paper
subtopic: Public Sector Economics,Capital Markets and Capital Flows,Securities Markets Policy & Regulation,Capital Flows,International Trade and Trade Rules,Macroeconomic Management,Public Finance Decentralization and
            Poverty Reduction,Armed Conflict
teratopic: Agriculture
abstracts: cdata!: Previous sharp oil price declines have
            been accompanied by elevated ex post volatility. In
            contrast, volatility was much less elevated during the oil
            price crash in 2014/15. This paper provides evidence that
            oil prices declined in a relatively measured manner during
            2014/15, with dispersion of price changes that was
            considerably smaller than comparable oil price declines.
            This finding is robust to nonparametric and GARCH measures
            of volatility. Further, the U.S. dollar appreciation exerted
            a strong influence on volatility during the recent crash; in
            contrast, the impact of shocks on equity markets was muted.
repnme: repnme: Sources of volatility during four oil price crashes
display_title: Sources of volatility during four
            oil price crashes
listing_relative_url: /research/2015/09/25093894/sources-volatility-during-four-oil-price-crashes
topicv3: Price Volatility m1326059 1150,Trade m1326924 698,Treasury m1327009 1045,Political Violence and War m1327310 2462,Equity Finance m1327686 334
publishtoextweb_dt: 2015-09-28T00:00:00Z
historic_topic: Agriculture
no_of_pages: 14
author_keys: 0: author_key: 96507
1: author_key: 810339
model_extractions: WPS7425 Policy Research Working Paper 7425 Sources of Volatility during Four Oil Price Crashes _John Baffes Varun Kshirsagar_ Development Economics Vice Presidency Prospects Group September 2015
Policy Research Working Paper 7425

# **Abstract**

Previous sharp oil price declines have been accompanied by elevated ex post volatility. In contrast, volatility was much less elevated during the oil price crash in 2014/15. This paper provides evidence that oil prices declined in a relatively measured manner during 2014/15, with dispersion of price changes that was considerably smaller than comparable oil price declines. This finding is robust to nonparametric and GARCH measures of volatility. Further, the U.S. dollar appreciation exerted a strong influence on volatility during the recent crash; in contrast, the impact of shocks on equity markets was muted.

This paper is a product of the Prospects Group, Development Economics Vice Presidency. It is part of a larger effort by the World Bank to provide open access to its research and make a contribution to development policy discussions around the world. Policy Research Working Papers are also posted on the Web at http://econ.worldbank.org. The authors may be contacted at jbaffes@worldbank.org.

_The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent._ Produced by the Research Support Team
# **Sources of Volatility during Four Oil Price Crashes**

**John Baffes** <u>jbaffes@worldbank.org</u>

**Varun Kshirsagar** <u>varun.kshirsagar@gmail.com</u>

**KEY WORDS** : Crude oil price, price volatility

**JEL** : Q43, Q47, E39
# **I. Introduction**

The dollar value of crude oil declined 51.2 percent in 83 trading days (October 1, 2014 to January 29, 2015).<sup>**1**</sup> Since 1984, when oil started trading on futures exchanges, there have been only three other episodes with comparably large declines (Figure 1). The largest took place during the financial crisis of 2008/09 (oil prices declined by 76.7 percent in 113 trading days), followed by the 1985/86 crash when OPEC abandoned price targeting (oil prices declined by 66.4 percent in 82 trading days), and the crash related to the first Gulf War when prices declined by 47.9 percent in 71 trading days. During each of these three episodes, oil price volatility was about twice as large (above 4.6 percent in all cases) as the historical average (2.4 percent). In contrast, volatility was considerably less elevated during the recent oil price crash at 2.6 percent (Figures 2 and 3).

We use a number of nonparametric measures of volatility and a GARCH (1,1) es‐ timate to document the “missing” oil price volatility during the 2014/15 crash.<sup>**2**</sup> Candidate explanations for the 2014/15 crash (e.g., OPEC’s abandonment of price support) are con‐ sistent with large declines on the days that the market absorbs relevant news. Yet, the maximum daily decline during the crash (5.5 percent) was less than half the maximum declines during the earlier crashes and there was also considerably less dispersion around the mean decline—consistent with the narrative involving a measured fall in prices.

# **II. Empirical Model**

We employ a GARCH (1, 1) model (Bollerslev 1986; Engel and Patton 2001) to estimate daily oil price volatility and identify the influence of equity market and exchange rate

> **1** The reasons behind the oil price plunge have been discussed elsewhere (e.g., Arezki and Blanchard 2014; Baffes et al 2015).

> **2** The ex‐post measures of volatility used here are different that the implied volatility based on option prices—which measure market expectations of volatility before it is realized.

<!-- Start of picture text --> 2 —<br><!-- End of picture text --> _— 2 —_
ret T bill, Re" = logtPe" Pelt) pe Et Var(e,) = of = a,€7_, + a,07., + exp (a + a,R ott + a,R od + asRett*l + aR). Equity[e] XR[e] Rey Rey exp (a 1 <u>ape 4 a, Remit] 4 are 4 aR)</u> E(o*) = ~~—-s—~~ (1 — a, — a2) (2) (3)
considerably less dispersion around this mean during the earlier three crashes (Table 1). The standard deviation of returns during the recent crash was 2.6 percent, similar to the historical average of 2.4 percent, but about half the magnitude of the earlier crashes. In contrast to the other crashes, the inter‐quartile range (2.9 percent) was also much closer to the historical average of 2.3 percent. The proportion of days when prices fell by more than 2 percent was less than the other crashes as well (though greater than the historical average); the number of days when prices rose by more than 2 percent was also less than all three previous crashes and the historical average. Last, a measure of the proportion of ‘stable’ days (i.e. days in which absolute log returns did not exceed 2 percent) was much closer to the historical average than to values associated with the three previous oil price crashes.

To confirm these observations and also identify drivers of volatility during each crash period, we estimate a GARCH specification as discussed earlier, the results of which are reported in Tables 2 and 3. The specification is applied to seven samples: 1985‐ 2015 (full sample), 1985‐2003 (pre‐boom period), 2004‐2015 (post‐boom period), and four 250 day periods ending with the end of each crash.

We draw three conclusions. First, while shocks to volatility have a smaller half‐life during oil price crashes, of the four crashes, the half‐lives are larger (greater than 12 days) for the crashes involving a loss in price support from OPEC (1985/86 and 2014/15) com‐ pared to the crashes engendered by the first Gulf War (1985/86) and financial crisis of 2008/09 (which each exhibited a half‐life of just 2 days).

Second, positive equity market shocks during the three previous crashes were as‐ sociated with greater volatility while this was not the case during the recent crash. Fur‐ ther, negative equity shocks were associated with greater volatility during the crashes of the first Gulf War and financial crisis. For example, while unconditional variance (with no equity shocks) was just 3.5 percent during the 2008/09 crash, the conditional variance <!-- Start of picture text --> 4 —<br><!-- End of picture text --> _— 4 —_
was six times as high (22.3 percent). The recent crash was not associated with either pos‐ itive or negative equity shocks.

Third, in contrast to the other crashes, the appreciation of the U.S. dollar was as‐ sociated with greater volatility during the crashes of 1991/92 and 2014/15. A 0.5 percent appreciation in the exchange rate is associated with a 39.6 percent increase in variance during the 2014/15 crash and a 12.1 percent increase during the first Gulf War crash.

For robustness, we re‐estimate the parameters for each crash period using three sample windows—the full sample, the relevant sub‐sample (either the pre‐boom period before 2004 or the boom period starting in 2004), and the 250‐day window that ends with the end of each crash (Table 3). The results indicate that the mean volatility (estimated using the GARCH specifications) for each crash period is similar for sample windows of different sizes. Similar to the previous estimates, the conditional variance for the latest crash period is estimated to be between 4.3 percent and 6.1 percent while estimates of the conditional variance of the earlier crashes are about four times as high (ranging from 15.2 to 24.9 percent). Finally, we estimated the model for the post‐2000 period using the Brent benchmark and the MSCI world equity index; the results were substantively similar for the relevant periods.

# **IV. Conclusion**

It has often been argued that we are now in an era of higher “commodity price volatility” (Dobbs et al 2011; McNally and Levi 2011). In this context, it is tempting to assert that the 2008/09 and 2014/16 crashes reflect structural changes in commodity markets that have engendered greater oil price volatility. However, this note documented that oil price vol‐ atility during the 1985‐2003 period was nearly identical to that of the 2004‐2015 period (Table 1).

We show that there are two key differences between the 2008/09 and 2014/15 oil <!-- Start of picture text --> 5 —<br><!-- End of picture text --> _— 5 —_
price crashes. First, oil prices declined in a relatively measured manner in 2014, with the dispersion of price changes (around a downward drift) that was considerably smaller than comparably large oil price declines.<sup>**3**</sup> Second, the U.S. dollar appreciation exerted a strong influence on volatility during the recent crash, while in contrast, the impact of shocks to equity markets was muted.

> **3** Volatility exhibited an upward trend after the 2014/15 crash ended (see Figure 2).

<!-- Start of picture text --> 6 —<br><!-- End of picture text --> _— 6 —_
# **Table 1**

# **Oil Price Summary Statistics**

||**Full**<br>**Sample**<br>_1985‐2015_|**Pre‐**<br>**Boom**<br>_1983‐2003_|**Post‐**<br>**Boom**<br>_2004‐2015_|**Crash 1**<br>_11/25/85‐_<br>_03/31/86_|**Crash 2**<br>_11/08/90‐_<br>_02/21/91_|**Crash 3**<br>_07/14/08‐_<br>_02/19/09_|**Crash 4**<br>_10/01/14‐_<br>_01/29/15_|
|---|---|---|---|---|---|---|---|
|**Nominal price level statis**|**tics**|||||||
|Maximum|145.29|40.42|145.29|31.70|35.53|145.18|91.01|
|Minimum|10.42|10.42|32.48|10.42|18.50|33.87|44.45|
|Max to Min change (%)|—|—|—|‐66.4|‐47.9|‐76.7|‐51.2|
|**Returns statistics**||||||||
|Mean|0.01|0.01|0.01|‐1.33|‐0.35|‐1.29|‐0.86|
|Standard Deviation|2.38|2.42|2.32|4.69|5.18|4.62|2.58|
|Interquartile Range|2.31|2.26|2.41|4.82|6.00|5.54|2.90|
|Skewness|‐0.22|‐0.36|0.06|0.01|0.00|0.41|‐0.39|
|Kurtosis|8.69|9.02|7.97|3.36|3.46|3.80|4.84|
|**Distribution of quartiles**||||||||
|Minimum|‐17.45|‐17.45|‐13.07|‐13.91|‐13.17|‐12.60|‐10.79|
|Median|0.03|0.00|0.06|‐1.37|‐0.27|‐1.27|‐0.89|
|Maximum|16.41|14.03|16.41|11.04|12.68|14.55|5.49|
|25<sup>th</sup>percentile|‐1.12|‐1.07|‐1.19|‐3.84|‐3.32|‐4.54|‐2.21|
|75<sup>th</sup>percentile|1.20|1.19|1.22|0.98|2.68|1.00|0.70|
|**Fraction of days with shoc**|**ks**|||||||
|Greater than +1%|0.28|0.28|0.29|0.24|0.39|0.26|0.18|
|Greater than +2%|0.15|0.15|0.14|0.20|0.32|0.19|0.10|
|Less than ‐1%|0.27|0.26|0.28|0.52|0.45|0.54|0.45|
|Less than ‐2%|0.14|0.14|0.15|0.44|0.30|0.43|0.29|
|Fraction of stable days|0.71|0.72|0.71|0.37|0.38|0.37|0.61|
|_Observations_|_7,575_|_4,759_|_2,816_|_82_|_71_|_113_|_83_|

**Notes** : “—“ indicates not applicable. The observation for January 17, 1991 has been excluded—it dropped 33 percent, from $32.00/bbl on January 16 to $21.22/bbl on January 17 (it was the day coalition forces in‐ vaded Iraq, consequently reducing the likelihood of oil supply disruptions). The ‘fraction of stable days’ denotes the number of days with absolute daily oil price changes that do not exceed 2 percent.

<!-- Start of picture text --> 7 —<br><!-- End of picture text --> _— 7 —_
# **Table 2 GARCH (1, 1) Estimates**

||**Full**<br>**Sample:**<br>_1985‐2015_|**Pre‐**<br>**Boom:**<br>_1985‐2003_|**Post‐**<br>**Boom:**<br>_2004‐15_|**Crash 1:**<br>_11/19/85‐_<br>_04/31/86_|**Crash 2:**<br>_11/09/90‐_<br>_02/22/91_|**Crash 3:**<br>_07/02/08‐_<br>_02/13/09_|**Crash 4:**<br>_10/01/14‐_<br>_01/28/15_|
|---|---|---|---|---|---|---|---|
|**Mean equation**||||||||
|�|0.02|0.01|0.02|‐0.46|‐0.63|‐0.85|‐0.57**|
|�|(0.82)|(0.13)|(0.48)|(0.28)|(0.20)|(1.59)|(2.44)|
|�����|0.00|0.01|0.03|0.07|0.10|0.47*|13.27**|
|�|(0.03)|(0.08)|(1.57)|(0.30)|(0.24)|(1.79)|(2.21)|
|**Variance equation**||||||||
||‐2.58***|‐1.62*|‐3.13***|‐2.13|‐0.46|‐0.08|‐2.58***|
|��|(5.87)|(1.64)|(7.09)|(0.96)|(1.32)|(0.16)|(3.72)|
|�|0.06***|0.10***|0.06***|0.28|0.02|0.07|0.00|
|����|(7.58)|(5.91)|(4.32)|(0.87)|(0.28)|(1.03)|(0.02)|
|�|0.93***|0.01***|0.92***|0.67**|0.69***|0.67***|0.95***|
|����|(111.9)|(85.2)|(53.1)|(1.99)|(8.20)|(4.91)|(56.5)|
|�<br>���������|0.18|0.57|‐0.98|2.75**|1.21***|0.52**|‐4.53|
|���|(1.00)|(0.08)|(1.52)|(2.20)|(3.81)|(6.27)|(0.99)|
|�<br>���������|‐0.53**|0.32|‐0.62***|‐1.08|‐1.20***|‐0.42***|13.9|
|���|(2.42)|(1.60)|(4.07)|(0.50)|(4.53)|(3.38)|(1.30)|
|�<br>�����|‐2.27|10.68|‐0.38|‐210.6|3.41***|‐0.74|6.66***|
|�|(1.16)|(0.68)|(0.19)|(0.60)|(4.39)|(1.02)|(9.12)|
|�<br>�����|16.72**|18.43|‐0.86***|1.48|‐0.30|‐0.42|‐0.14|
|�|(2.16)|(1.20)|(2.99)|(0.46)|(0.25)|(1.07)|(0.02)|
|**Key test statistics**||||||||
|Log‐Likelihood|‐15700|‐9929|‐5760|‐460|‐684|‐619|‐439|
|Box‐Ljung test (1 lag)|38***|40***|36***|29***|22***|248***|7268***|
|Persistence (GARCH)|0.996***|0.994***|0.988***|0.957***|0.713***|0.737***|0.947***|
|Half Life (days)|161.4|116.7|54.4|15.7|2.0|2.3|12.7|
|_Observations_|_7,325_|_4,603_|_2,722_|_250_|_250_|_250_|_250_|

**Notes** : One (*), two (**), and three (***) asterisks denote parameter estimate significant at the 10, 5, and 1, percent levels.

<!-- Start of picture text --> 8 —<br><!-- End of picture text --> _— 8 —_
# **Table 3 Robustness Checks**

||**Crash 1:**<br>_11/19/85‐_<br>_04/31/86_|**Crash 2:**<br>_11/09/90‐_<br>_02/22/91_|**Crash 3:**<br>_07/02/08‐_<br>_02/13/09_|**Crash 4:**<br>_10/01/14‐_<br>_01/28/15_|
|---|---|---|---|---|
|**Sample variance (from table 1)**|22.0|26.9|21.4|6.6|
|**Conditional variances, based on the different es**|**timation windows**||||
|Full sample|15.4|23.7|18.9|6.1|
|Pre‐boom/post‐boom|15.2|23.2|21.3|5.7|
|250‐day window|20.8|24.9|22.3|4.3|
|**Other statistics, based on 250‐day window**|||||
|Unconditional variance|2.7|2.2|3.5|1.4|
|Mean, +1% equity|43.0|7.5|5.9|—|
|Mean, ‐1% equity|—|7.3|5.3|—|
|Mean, +0.5% exchange rate|—|12.1|—|39.6|
|Mean, ‐0.5% exchange rate|—|—|—|—|

**Notes** : Row 1 reports the square of the standard deviation, shown in the second panel of table 1. A cell is assigned “—“when the driver is not statistically significant at a 5% level.

<!-- Start of picture text --> 9 —<br><!-- End of picture text --> _— 9 —_
<!-- Start of picture text --> Figure 1<br>Oil Prices (WTI), U.S. CPI-deflated<br><!-- End of picture text --> <!-- Start of picture text --> US$/barrel<br>First Gulf War: 2008 financial crisis:<br> 150<br>Price drops 48% in 71 days Price drops 77% in 113 days<br> 120<br> 90<br> 60 Sample average price: $52.28/barrel<br> 30<br>OPEC abandons price targeting: OPEC abandons price targeting:<br>Price drops 66% in 82 days Price drops 51% in 83 days<br> ‐<br>Jan‐70 Sep‐73 May‐77 Jan‐81 Sep‐84 May‐88 Jan‐92 Sep‐95 May‐99 Jan‐03 Sep‐06 May‐10 Jan‐14<br>Source : World Bank<br>Note : Last observation is February 2015. Oil prices, which refer to WTI have been deflated by the U.S. CPI (2014 terms)<br><!-- End of picture text -->

# **Figure 2 Oil Price Volatility, 1985-2015**

<!-- Start of picture text --> Std. Dev. of [log p(t)/p(t‐1)]*100<br> 7<br>OPEC abandons 2008 financial crisis<br> 6 price targeting<br>First Gulf War<br> 5 OPEC abandons<br>price targeting<br> 4<br> 3<br> 2<br> 1<br> ‐<br>1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014<br>Source : World Bank<br>Notes : Volatility is the standard deviation of the oil price (WTI) changes, presented as a 60‐day trailing window.<br><!-- End of picture text --> <!-- Start of picture text --> 10 —<br><!-- End of picture text --> _— 10 —_
# **Figure 3 Heightened Price Volatility during Three Previous Oil Price Crashes**

<!-- Start of picture text --> 35US/bbl 1985/86 Vol8 35US/bbl Price (left) 1990/91 Vol 8<br>Price (left) Volatility (right) Volatility (right)<br>30<br>6 30 6<br>25<br>4 25 4<br>20<br>2 20 2<br>15<br>10 0 15 0<br>1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81 86 1 6 11 16 21 26 31 36 41 46 51 56 61 66 71<br>100 8<br>150 2008/09 8 2014/15<br>90<br>130<br>6<br>6<br>80<br>110<br>90 4 70 4<br>70 60<br>2 2<br>50 50<br>30 0 40 0<br>1 11 21 31 41 51 61 71 81 91 101 111 121 131 141 151 1 6 11 16 21 26 31 36 41 46 51 56 61 66 71 76 81<br><!-- End of picture text -->

**Notes** : Volatility is the standard deviation of the oil price (WTI) changes and is presented as a 30‐day trailing window.

<!-- Start of picture text --> 11 —<br><!-- End of picture text --> _— 11 —_