Oil prices behave differently over different time-horizons. For the short run, we examine the pattern of movements in crude oil prices over business cycles and test whether price increases influence global output and/or are influenced by economic cycles. For the long run, we focus on whether "shocks" to crude oil prices are persistent or not. Our findings indicate that the price of crude oil exhibits substantial cyclical behaviour, as verified by several tests carried out in this paper. The VAR analysis indicates that the price of oil is a pro-cyclical variable. Moreover, the results show that, while, during the 1972-2003 period (when OPEC exerted more influence in the oil market), the oil market experienced substantial fluctuations in price, the price cycles were mean-reverting and not shockpersistent. This could indicate that OPEC market power can have stabilising effects.
The crude oil price exhibits a high degree of volatility which varies significantly over time. Such characteristics imply that the oil market is a promising area for testing volatility models. Testing and predicting volatility using ARCH and GARCH models have grown in the literature. A useful application of the volatility models is in the formulation of hedging strategies. In this paper we compare the optimal hedge ratio for the crude oil using the classical minimum risk approach and use ARCH to incorporate the effect of heteroskedasticity in the residuals on the hedge ratio. In addition, we test for the existence of a variable risk premium in the crude oil market. We find that, assuming rational expectations, there is a non-zero risk premium. We test for the variability of the risk premia and find evidence in its support when we employed a multivariate GARCH model. Copyright 2006 Organization of the Petroleum Exporting Countries.
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