Managing Oil Price Risk: Dealing with the Time-Varying Relationship between the Price of Oil and Fundamentals

Ronald Huisman and Mehtap Kiliç

INTRODUCTION

To measure price risk, we need to understand the dynamics of the probability distribution of potential price changes over some future period, at least in terms of the mean expected price change and its variance. Time-series approaches, that purely rely on time-series patterns and not on fundamentals, help to determine short-run price trends and volatility patterns. For the longer-run, market fundamentals may change and we need to incorporate this in order to assess risk for longer horizons. Developments in fundamentals, such as the rapid decrease of shale oil production costs and the resulting increase in shale oil supply, significantly change the mean oil price level and might as well lead to a different volatility level. Of course it is not possible to forecast the future and to picture all future developments in fundamentals, but we can follow the development of some fundamental drivers of the oil price over time and how they relate with the price of oil. This chapter discusses how we can do that.

A vast amount of literature has proposed fundamental drivers that determine the price of oil. Fan and Xu (2011) classify these in three categories: i) market factors