Managing geopolitical risk in petroleum markets

What the paper says

Petroleum market insecurity as may arise from geo-political events is a perennial concern. The rise of modern industrial economies and global conflicts have made secure supply paramount. Although instances of actual disruption are rare, the perception exists that geo-political risks are a threat to secure supply especially since petroleum markets evolved from bi-lateral relationships between oil-major and exporting countries, to become a traded commodity. Examining historic shocks to petroleum markets, we show the use of futures and options, derivatives, in managing risk during extreme conditions challenge the view that concerns of supply disruption are warranted. Though the utility of futures and options markets in managing ‘day-to-day’ firm level exposure is acknowledged, concerns remain that derivative markets cannot handle either the risks associated with historic geo-political shocks or yield macro benefits. Using historic data from various Exchanges of trader intentions, commercial and non-commercial activity, positioning is statistically related to both volatility and price level. Faced with geo-political risk, price instability and stochastic volatility, positions are taken to mitigate exposure while yielding social benefits in stabilising markets. Further, notwithstanding perceptions of insecurity, using option theory, we show that market participants attached a low probability to illiquidity or price extrema during episodes of geo-political events. Finally, we address the extent to which the specifications of option models present a limitation to managing the risks associated with exogenous perturbations. Our results support the argument that the existence of geo-political risk is manageable and historic concerns over market insecurity, are exaggerated.